An adjustable-rate mortgage (ARM) is a type of home loan that offers a unique set of features. Unlike fixed-rate mortgages, which have the same interest rate for the life of the loan, adjustable-rate mortgages have interest rates that can change. This is because your ARM's interest rate is tied to a broader market index. When that index rises or falls, so does your mortgage rate.
ARMs are popular because they often start you out with a lower introductory interest rate than a fixed-rate mortgage. This means a lower monthly payment during the early years of your loan. But it's important to remember that your rate and monthly payment aren't set in stone. Your ARM's interest rate can increase or decrease at set times, and it can affect your payment significantly.
Pros ans Cons
- Lower initial interest rate. ARMs often start you out with a lower interest rate than fixed-rate mortgages. This means a lower monthly payment during the early years of your loan.
- Lower payments over the life of the loan. If you keep your ARM for its entire life, you'll pay less in interest over time than you would with a fixed-rate mortgage.
- Lower mortgage payment. A lower initial interest rate means a lower monthly payment during the early years of your loan.
- Lower payment based on future interest rates. As interest rates are cyclical, they may fall in the future. A lower interest rate could give you an even lower monthly payment.
- More home for your money. ARMs often allow you to borrow more money than a fixed-rate mortgage would qualify you for.
- Plan for future increased income: If you're planning to move into a more expensive home in a few years, an ARM might be a good choice. You can handle a higher monthly payment when your income increases.
- Stress on your budget. The possibility of a much higher payment and uncertainty about what your payment will be in the future can cause financial stress
- Difficulty refinancing. If interest rates rise and you're unable to afford your ARM's higher payment, you may not be able to refinance to a lower rate. You could be stuck with a payment that's difficult to manage.
- Higher costs over the life of the loan. Although ARMs are often cheaper in the early years, they can end up costing more over the life of the loan.
- No one knows for certain what the future holds, and it's impossible to predict exactly how interest rates will change.
- Higher payment risk. As interest rates are cyclical, there's a good chance your ARM's rate will increase over time, making your monthly payment more difficult to manage.
How do adjustable-rate loans work?
Adjustable-rate loans are hybrid mortgages because they combine the features of fixed-rate and adjustable-rate loans. A fixed-rate period is the defining characteristic of an adjustable-rate loan. During that time, your interest rate and monthly payment are set. How long that fixed-rate period lasts varies by loan. Some ARMs have 3-year, 5-year, 7-year or 10-year fixed-rate periods. The longer the fixed-rate period, the higher your introductory interest rate is likely to be.
That introductory rate is often lower than a fixed-rate mortgage's interest rate, which is why adjustable-rate loans are popular. You'll pay less in interest over the life of the loan if you keep your ARM for its entire life, and you'll have a lower monthly payment during that initial fixed-rate period.
What you need to know about adjustable-rate loans
Loan term. How long you borrow the money. This is the same for all mortgage loans, and it determines your monthly payment.
Fixed-rate period. How long your introductory interest rate and monthly payment are set.
Adjustment period. How often your ARM's interest rate can adjust. This could be every year, every six months or monthly.
Interest rate cap. The maximum amount your interest rate can increase by at each adjustment and overall. This is where your ARM's three numbers come in. The first number is the initial cap, the second is the subsequent/periodic cap and the third is the lifetime cap.
Let's say you have a 5/2/5 ARM with a 5% introductory rate. Your monthly payment is based on that low rate for five years. After that, your rate can adjust annually, and it can't go more than 5% above your initial 5% rate (2%). The lifetime cap is 15% above your initial rate.
The risks of an adjustable-rate mortgage
While lower monthly payments during the early years of your loan can be a big help, it's important to consider the risks of an ARM. If your interest rate adjusts higher, your monthly payment could be more difficult to manage. You'll want to make sure you have a plan in place to handle higher payments, whether that's by paying down your principal faster or setting aside a cushion in case of a rate increase.
Types of adjustable-rate mortgages
Several types of adjustable-rate mortgages (ARMs) are available, and each has its own characteristics that affect your monthly payment and interest rate. Here are a few:
Traditional ARM. A traditional ARM, also known as a swing loan or straight ARM, has a fixed interest rate for a set number of years (3, 5, 7 or 10) and then adjusts annually or at other predetermined times. This type of ARM is a good choice if you plan to move before your loan's initial fixed period ends.
Hybrid ARM. A hybrid ARM combines the features of fixed-rate and adjustable-rate loans. It starts you out with a fixed interest rate for a set number of years (5, 7 or 10) and then adjusts your rate annually or every six months. Hybrid ARMs offer a balance between the security of a fixed-rate mortgage and the flexibility of an adjustable-rate loan.
Interest-only ARM. An interest-only ARM lets you pay just the interest on your loan for a set number of years (5-10). This is also known as a negative amortization loan. Once the interest-only period ends, you'll start paying both interest and principal. Interest-only ARMs can be helpful if you need a low monthly payment and plan to move up to a larger home or invest the difference in your mortgage.
Payment-option ARM: A payment-option ARM is the most flexible type of mortgage available. You can choose how much you pay each month: interest only, minimum payment, 15-year or 30-year amortization or make a payment based on a hybrid option. The minimum payment can be less than the interest owed, which means you'll accrue negative amortization. Because of this, a payment-option ARM should be used with caution.
How interest rates on ARM loans are determined
An ARM loan's interest rate is not set in stone like a fixed-rate mortgage's rate. ARM interest rates can adjust periodically based on a variety of economic factors. The most important factor is the index rate, which is a benchmark rate that your ARM's interest rate is based on. A few common indexes in the United States are:
London Interbank Offered Rate (LIBOR)
11th District Cost of Funds Index (COFI)
Prime rate
Secured Overnight Financing Rate (SOFR)
U.S. Treasury rates
Your ARM's margin, which is a set percentage, is added to the index rate to determine your interest rate. For example, if your ARM's index is LIBOR + 2.5%, and LIBOR is 2.0%, your ARM's interest rate would be 4.5%.
Your lender also adds a margin to the index rate to determine your ARM's interest rate. This margin is a set percentage and is based on a variety of factors, including your credit score, loan amount and loan-to-value (LTV). A better credit score and higher loan-to-value ratios (meaning you made a smaller down payment) typically result in higher margins.
The index rate can move up or down in response to changing economic conditions. When the index rate rises, so does your ARM's interest rate. When it falls, your rate may decrease. Because of this, it's important to consider how an ARM's monthly payment could increase over time. If you're not prepared for higher payments, an ARM might not be the right choice for you.
A fixed-rate mortgage's interest rate stays the same the entire life of the loan, which is appealing to many homebuyers who value stability and predictability. A fixed rate helps you budget your monthly payment and plan for the future.
Because an ARM's interest rate isn't guaranteed and can increase over time, it's important to consider the risks before choosing an ARM loan.
When to get an adjustable-rate mortgage An adjustable-rate mortgage (ARM) is a good choice if you plan to sell or refinance in a few years. The lower initial interest rate and monthly payment can help you afford a more expensive home. You might also consider an ARM if you're comfortable with a certain amount of uncertainty and are confident you can handle a higher payment in the future. The initial lower rate can save you a significant amount of money compared to a fixed-rate mortgage, especially if you plan to sell or refinance before your ARM's rate adjusts. If interest rates are expected to rise in a few years, an ARM can be a good choice. You'll qualify for a lower rate than a fixed-rate mortgage offers during the initial fixed period. If rates are expected to fall in the future, you might consider a fixed-rate mortgage. A hybrid ARM could also be a good choice, as it offers a fixed rate for a set number of years (5, 7 or 10). An ARM isn't a good choice if you want maximum payment stability. If you're on a tight budget and can't afford much wiggle room in your monthly payment, a fixed-rate mortgage is likely a better fit.
Important
Keeping your Debt-to-Income (DTI) ratio below 30-40% of your monthly income is crucial. This will help you avoid potential financial problems in the future. Additionally, always assess the necessity and feasibility of taking a loan, ensuring you can comfortably manage its repayment.
How to Choose a Mortage Lender
Check Associations. Look for lenders who are members of reputable organizations, such as the Mortgage Bankers Association (MBA). Membership in these organizations can indicate a higher level of reliability and professionalism.
Review Terms and Conditions. Carefully examine all the terms and conditions of the mortgage contract. Pay special attention to details like the loan term, fixed vs. variable interest rates, and any prepayment penalties.
Interest Rates and Costs. Scrutinize the interest rates and ensure that your contract includes a detailed breakdown of the total cost of the mortgage, including closing costs, origination fees, and any other charges.
Right of Rescission. Remember you can utilize your right of rescission, which typically allows you to cancel the mortgage within three days after signing the agreement. Additionally, use the "cooling-off" period to thoroughly review the contract and make an informed decision before finalizing the mortgage agreement.
Compare Offers. Shop around and compare offers from multiple lenders to find the best rates and terms that suit your financial situation.
Additional resources
To learn more about mortgages and best practices, check out some of the following resources: