An adjustable-rate mortgage (ARM) is a type of home loan that offers a low fixed rate for the first few years, after which your interest rate and payment can move up or down with the market.
In a volatile market, mortgage rates can rise swiftly and with little warning. If rates go up, that means your payment will go up. However, the low introductory rate on an ARM could help lower your payment at the outset and boost your home-buying power.
So, are ARMs a good idea? Here’s what you need to know.
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The most common type of adjustable-rate mortgage in today’s market is the hybrid ARM. Hybrid ARM loans have two distinct periods: an introductory fixed-rate period and an adjustable-rate period. During the intro period or “teaser period,” your low interest rate and payment are fixed and cannot change. After that period expires, your rate and mortgage payment can typically increase or decrease once per year depending on market conditions.
Common ARM mortgage options include the 3/1, 5/1, 7/1, and 10/1 ARM. The first number indicates your fixed-rate period. With a 5/1 ARM, you would have an introductory fixed-rate period of five years. The second number (“1”) represents how often your interest rate could adjust up or down. Using the 5/1 ARM example, after your fixed rate expires, your interest rate could adjust up or down once each year.
Most hybrid ARMs have a total loan term of 30 years. So with a 5/1 ARM, you have a 5-year intro period and then 25 years during which your rate and payment can adjust each year. Note that modern adjustable-rate mortgages come with interest rate caps that limit how high your rate can go, so the cost can’t just increase every year for 25 years. It will stop at your loan’s cap.
There are a few important terms associated with adjustable-rate mortgages. It’s important to understand what these features are and how they work, as they determine your interest rate, your payment, and how much your mortgage can fluctuate over time.
Two key factors known as “index” and “margin” determine your ARM’s interest rate.
It’s also important to understand how adjustable mortgage rates work when it comes time for your rate to adjust. There are three kinds of “rate caps” that limit the amount your rate can increase each time it changes.
Rate caps are especially important to understand, as they limit how much your interest rate and mortgage payment can go up throughout the adjustment period of your loan. For example, rate caps for a 5/1 ARM might be shown as 2/2/5.
Say your initial ARM rate was 3 percent. With a rate cap structure of 2/2/5, your rate could increase up to 5% at its first adjustment; as high as 7% at its second adjustment; and no higher than 8% over the entire life of the loan.
Keep in mind that adjustable mortgage rate don’t always increase. If the index rate to which your loan is tied has fallen by the time your loan adjusts, your rate and payment also have to potential to go down.
The big difference between a fixed-rate mortgage (FRM) and an adjustable-rate mortgage (ARM) is that FRMs have a fixed interest rate and payment for the entire life of the loan. When you opt for an FRM, your rate and payment can never change unless you decide to refinance into a new mortgage loan.
Fixed-rate mortgages are the most popular choice for mortgage borrowers. The stable rate and payment make FRMs a safer option for homeowners because they never risk their payments rising and becoming unaffordable. The traditional 30-year fixed-rate mortgage is the most common type of home loan, followed by the 15-year fixed-rate mortgage.
Fixed-rate mortgages make up almost the entire mortgage market when rates are low. After all, why wouldn’t you lock in an ultra-affordable rate and payment for the life of the loan? However, ARM loans often grow in popularity when rates are rising. That’s because ARM intro rates are typically lower than fixed rates. This can help borrowers lower their costs and the outset and potentially afford more expensive homes on the same budget.
The pros of an adjustable-rate mortgage include:
Some cons of an ARM include:
These pros and cons warrant careful consideration. An adjustable-rate mortgage is a great tool for many home buyers, but it also comes with serious risks that borrowers need to be prepared for.
Adjustable-rate mortgages are best suited for homeowners who don’t plan on staying in their homes for more than a few years.
If you’re confident you’ll be moving before the fixed-rate period ends, an ARM could be a great choice. You’ll enjoy the perks of a cheaper introductory rate and payment, and then move before your low rate expires. If your plans change and you no longer plan to move, refinancing to a fixed-rate mortgage could be a viable option.
If you’re in the military and find yourself relocating every 4 to 5 years, for example, the lower initial rate and payments on an ARM could be a better option than a fixed-rate mortgage. An ARM can also be a great option for first-time homebuyers who plan to start a family and upsize to a bigger home within five to 10 years.
Thanks to rising mortgage rates, affordability has taken a toll on many home buyers. As a result, many would-be homeowners are considering ARMs. This allows them to still afford the home they want without having to compromise due to higher rates.
The interest rate and payment on an adjustable-rate mortgage can increase substantially over time. This is risky because it could make your mortgage payments unaffordable, especially if you have an unexpected financial change in the future like a job loss.
Why would a home buyer choose an adjustable-rate mortgage?If you’re buying a short-term home and plan to move away or upsize in a few years, an ARM could save you money. You could benefit from the lower rate and payment, then sell your home before the rate adjusts. An ARM can also be helpful in a rising-rate market where high fixed rates are pricing buyers out of the homes they wanted.
Do you pay principal on an ARM?Most mainstream ARM loan payments include both principal and interest. The only time you won’t pay principal on an ARM is if you opt for a special product like an interest-only or payment-option ARM. These can offer a lower payment that covers just the interest, or possibly not even all the interest due, for a period of time. But payments will balloon later on, and when this happens you will still have the full loan balance to pay off.
Can you pay off an ARM early?Some adjustable-rate mortgage loans come with an early payoff penalty. Not every lender charges prepayment penalties, and the length of time for the penalty may vary. Before choosing an ARM, be sure to ask your lender if you would incur any penalties should you decide to pay your loan off early.
Do ARM rates ever go down?It’s possible for your ARM rate to go down if interest rates fall and then your rate adjusts. However, it’s relatively rare for this to happen. ARM rates are much more likely to increase when they adjust than to decrease.
What happens after a 5-year or 7-year ARM?After your initial introductory period of five or seven years, your rate may go up or down according to the market. Be sure to read through the caps and adjustments associated with your ARM. An adjustment of two percentage points is typically the maximum adjustment for your first rate change.
Is an ARM a good idea right now?Rates rose significantly in 2022, making an adjustable-rate mortgage a great option for many would-be homeowners and refinancers. If your plans are to settle in and plant roots for an extended period of time, or the uncertainty of an ARM is frightening, you may be better suited for a fixed-rate mortgage.
Deciding between an adjustable-rate mortgage and a fixed-rate mortgage is an important consideration. As you explore your options, think about all the factors that could make an ARM ideal for your situation, or could make an ARM a challenge for you in the future.
Interest rates are on the rise. When you’ve decided which type of mortgage is best for you, reach out to a lender to get started right away.