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An adjustable-rate mortgage (ARM) is a home loan that starts with a lower fixed-rate for usually three to 10 years, followed by an adjustable-rate period. Your mortgage interest rate will fluctuate depending on the terms of your home loan and a benchmark rate index.
Compared to fixed-rate mortgages, adjustable-rate mortgages typically offer low rates in the initial period and less predictable rates throughout the life of the loan. Do the savings you may get in the initial period mean is the right move for you?
In this article, we define adjustable-rate mortgages and outline the different types, as well as the pros and cons. Here is everything you need to know.
An adjustable-rate mortgage, or ARM, is a home loan with an interest rate that is subject to rise and fall based on the market’s current rates in the USA. Compared to fixed-rate mortgages, adjustable-rate mortgages usually start with a lower interest rate, meaning an adjustable-rate mortgage is a good option if you want the lowest mortgage rate possible starting out.
It is important to know, however, that the interest rate on an adjustable-rate mortgage will likely change after the initial period, which is often five years. After this initial period, your monthly payments can rise or fall periodically, which can make it more challenging to budget for.
Unlike fixed-rate mortgages, adjustable-rate mortgages are long-term home loans that have two periods, which are as follows:
For example, if you take out a 30-year adjustable-rate mortgage with a five-year fixed period, you will have a low fixed rate for the first five years of the home loan and a rate that fluctuates over the remaining 25 years of the loan.
Adjustable-rate mortgages are divided between the initial fixed-rate period and the following adjustable-rate period, which is commonly expressed like this:
The 5 in the 5/6 and 5/1 represents the introductory, fixed rates that last five years; the 6 and the 1 in the numbers represent the six months or one year that the interest rates change. The most popular adjustable-rate mortgage is the 5/6 ARM, meaning that the interest rate changes every six months after the 5-year introductory fixed rate. The 5/6 ARM replaced the 5/1 ARM as the most popular option.
However, some mortgage lenders also offer 3/1, 7/1, and 10/1 ARMs, meaning that the introductory fixed rate lasts three, seven, or 10 years and the interest rate changes one time per year in all three options.
There are three main types of adjustable-rate mortgage, including:
Let’s take a closer look at each to see which may be best for you:
Interest-only adjustable-rate mortgages are when you pay only interest (no principal) for a certain period. After the interest-only period ends, you then begin making payments on the principal and interest. The interest-only period of these ARMs usually last between a few months and a few years, during which time your monthly payments are often low—since you are only paying interest—however, you are also not building any home equity, unless the property appreciates in value.
This option may, however, result in negative amortization, which means the balance of your home loan increases because you are not paying enough to cover the interest. If the balance increases too much, your mortgage lender may recast the loan and require that you make more significant payments, which may become unaffordable. It is important to weigh that risk when choosing a payment-option ARM.
Whether an adjustable-rate mortgage is a good idea for you will depend on your financial goals and your ability to handle risk. However, the first and most important you may want to ask yourself is how long you plant to live in the home.
If you sell your property or pay off your mortgage before the adjustable rate increases, you will end up saving money. If, on the other hand, you want to settle in for the long term and require the certainty of a consistent mortgage rate and monthly payment, then a fixed-rate mortgage would likely be a better idea for you.
For these reasons, using an ARM may make the most sense if you want to purchase a starter home and are unable to afford a fixed-rate mortgage. Since most first- and second-time home buyers typically stay in a home for an average of five years, an ARM is usually a good option.
There are many pros and cons of adjustable-rate mortgages. Whether an ARM is right for you, it is best to weigh these potential benefits and/or risks against your goals and comfort levels.
First, here are the pros of adjustable-rate mortgages:
To help you make your decision, let’s take a closer look at each of the pros:
A hybrid adjustable-rate mortgage will offer you potential savings in the fixed-rate period at the beginning, usually between three and 10 years. For instance, with a five-year ARM, your introductory interest rate is locked in before it can be changed. That means you will have five years of predictable and low payments.
That lower fixed rate may also allow you to qualify for a larger home loan that you would with a fixed-rate loan. If necessary, you can ask yourself if you will be able to make higher monthly payments in the future.
If your life is likely to change within the next few years—like if you plan to sell your property or move—an adjustable-rate mortgage might be a good idea. You can also benefit from the ARM’s fixed-rate period and sell the property before that initial period ends and the adjustable-rate phase begins.
Adjustable-rate mortgages have caps limiting how much your mortgage rate and your payment can increase, including how much the rate can change every time it adjusts, as well as the total rate change over the lifetime of the loan.
Your monthly mortgage payments may drop if interest rates decrease, driving down the index against which your adjustable-rate mortgage is benchmarked. If you think this is a possibility, you might want to go with an ARM. Keep in mind, however, that is always better to make this decision based on your own personal financial situation, rather than what you think will happen to the market.
There are cons to adjustable-rate mortgages. To help you better understand the risks of ARMs, these cons include:
Here is a closer look at each:
You have to plan for when the interest rate starts fluctuating and monthly payments increase. Even if you do plan carefully, you may be unable to sell your property or refinance when you want to. By missing payments after the fixed-rate period of the mortgage ends, you may end up losing the home.
The short answer: An adjustable-rate mortgage is good for buying more house. Like most home buyers, you are likely budgeting for monthly payment amounts rather than the total price of the home. If, however, you want to buy more properties, an adjustable-rate mortgage may be your best bet.
With an adjustable-rate mortgage, you spend less money on initial interest charges, freeing up the funds to invest more into your principal mortgage payment. Even one percentage point of interest can significantly alter your monthly payment by $200 to $300.
Home buyers who would be good candidates for an adjustable-rate mortgage include the following:
There are numerous benefits and risks to getting an adjustable-rate mortgage, including how long you want to stay in your home and how comfortable you are with risk, due to fluctuating mortgage rates, in the long term.
Before committing yourself to getting an adjustable-rate mortgage, do your research, such as checking in on what the best mortgage lenders in your area can do for you. That way you can find the option that best fits your financial situation, both now and in the future.
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