An adjustable-rate mortgage (also called an ARM) is a mortgage where the interest rate changes. Monthly payments may go up or down.
Borrowers may be looking to save money with this type of mortgage because there’s usually an introductory period where the interest rate is lower than what they could get with a fixed-rate loan. The monthly payment is lower as a result.
Adjustable-rate mortgages can make sense in certain situations, such as when buyers only plan to own a home for a few years or for those looking to buy a home in a high-interest-rate environment. However, they’re not your only option if you’re looking at getting a mortgage in a high-interest-rate environment.
In this article, we’ll cover
• What exactly is an adjustable-rate mortgage and how do they work?
• What are the different types of ARMs you can apply for?
• Pros and cons of an ARM
• How the variable rate on an ARM is determined
• How an ARM compares with a fixed-rate mortgage
• Examples of when it does and doesn’t make sense to get an ARM
What Is an Adjustable-Rate Mortgage (ARM)?
An adjustable-rate mortgage is a type of mortgage loan where the interest rate can change periodically throughout the life of the loan. This means your monthly payment might increase or decrease over time.
They typically come in shorter terms, such as five, seven, or ten years and adjustment periods (how often the interest rate is evaluated and changed) of six months or one year. They may be useful as a financing tool for short-term situations, but there are some things to consider before taking on a mortgage like this.
How Adjustable-Rate Mortgages Work
The terms of an adjustable-rate mortgage are determined at the outset of the loan. You’ll decide on a type of ARM, apply with the lender of your choice, and start making payments once the loan closes.
What’s different about an ARM from other home mortgage loans is the interest rate will adjust periodically and your monthly payment will change. It’s typical to see an introductory period (a number of years) where your interest rate doesn’t change, however.
Types of Adjustable-Rate Mortgages
If you’ve started to look into financing a home purchase, then you’ve probably seen loans labeled with different numerals. Maybe you’re wondering, what is a 5/1 ARM? When you’re choosing mortgage terms, the different types of ARMs you can get correspond to the different terms (with 5, 7, and 10 year ARMs being the most common) and adjustment periods (typically 1 year or six months). An ARM is labeled with two numbers, first with the number of years in the introductory period, followed by the period when the interest rate will reset. A 5/1 ARM, for example, has a 5-year introductory period followed by one adjustment per year to the interest rate.
Here are some other examples:
• 5/6: A five-year term with an adjustment period of six months.
• 7/1: A seven-year term with an adjustment period of one year.
• 7/6: A seven-year term with an adjustment period of six months.
• 10/1: A ten-year term with an adjustment period of one year.
• 10/6: A ten-year term with an adjustment period of six months.
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Pros and Cons of Adjustable-Rate Mortgages
If you’re considering an ARM, you’re probably weighing the lower payment against future financial positions you’ll need to take. There are some other pros and cons to consider.
Pros
• Many different term lengths to choose from
• Low annual percentage rate
• May start with a lower monthly payment than a fixed-rate mortgage
• May be slightly easier to qualify for
Cons
• Interest rate can change
• You could end up with a higher monthly payment
• If you’re unable to afford the higher monthly payment, your home could be in danger of foreclosure
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How the Variable Rate on ARMs Is Determined
To fully understand how does an adjustable-rate mortgage work, it helps to see what’s going on behind the scenes of an ARM and how the rate is determined. You’ll be looking at these four components:
1. Index
2. Margin
3. Interest rate cap structure
4. Initial interest rate period
Index
The cost of an ARM is tied to a market index, generally the secured overnight financing rate (SOFR). These can increase when the federal funds rate rises.
Margin
The margin is the percentage points added to the cost of the index. It is disclosed when you apply for the loan and can vary from lender to lender, so be sure to shop around!
The interest rate on your ARM is equal to the index plus the margin.
Interest rate cap structure
There are three types of rate caps: initial, periodic and lifetime. For the initial period, the cap is on how much interest you’ll be charged in the first period of your loan. For example, in a 5/1 ARM, you’ll have an interest rate that stays the same for the initial period of 5 years.
When your initial period is over, you’ll have periodic adjustments. These will have a separate cap for how much your interest rate can increase over the defined period (usually six months or a year).
You’ll also have a cap on how much your interest rate can increase over the life of the loan.
Initial interest rate period
The cost of an ARM is also determined by how long the interest remains constant for the initial period. ARMs with longer initial periods generally have higher rates. A 7/1 ARM will have a higher APR than a 5/1 ARM, for example.
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Adjustable-Rate Mortgage vs. Fixed-Interest Mortgage
When it comes to fixed-rate vs adjustable-rate mortgages, the mortgages are structured very differently. Here’s a quick breakdown of the major differences:
| Adjustable-Rate Mortgage | Fixed-Rate Mortgage |
|---|---|
| Interest rate adjusts | Interest rate stays the same |
| Terms are usually shorter, such as 5 to 7 years | Terms are usually longer, such as 15 or 30 years |
| Loans are often refinanced at a later date | Loan can be paid off |
| May have lower interest rate initially | Interest rate does not change |
| Monthly payment changes | Predictable monthly payment |
| Interest rate you pay is tied to economic conditions | Interest rate determined at the origination of the mortgage |
The main difference between fixed-rate and adjustable mortgages is in how you pay interest on the loan. With a fixed loan, the interest is paid with regular monthly payments, which are fairly set (except for fluctuations with escrow items). With an adjustable-rate mortgage, the interest you pay can change.
The other major difference between the two types of mortgages is the term length. Fixed mortgages are often financed at 15- or 30-year terms. ARMs are usually held for shorter periods of time.
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Example of When Adjustable-Rate Mortgages Makes Sense
There are a few scenarios where an ARM makes sense.
• If you’re only planning to keep the home (or keep the mortgage) for a few years.
• Interest rates are very high.
In each of these situations, borrowers — including first-time homebuyers — don’t plan to hold onto the mortgage long-term. They’re looking to sell the property or refinance at a future date.
However, there are times where an ARM doesn’t make a lot of sense.
Example of When Adjustable-Rate Mortgages Doesn’t Make Sense
An ARM may not make sense when the interest rate for a fixed-rate mortgage is low. This was common just a few years ago, and buyers who have these low-interest, fixed-rate mortgages don’t need to worry about getting another mortgage.
If you’re considering purchasing a home with an ARM, you may also want to look at buying down the interest rate on a fixed-rate mortgage with points, especially if you plan on staying in the home long-term.
Can You Refinance an ARM?
Many borrowers get an ARM with the expectation that they will be able to refinance into a different mortgage at a later date. Refinancing any mortgage, including an ARM, will depend on your ability to qualify for it. If your credit score or income take a serious hit, for example, you may not be able to refinance an ARM to get a more attractive rate. It’s also possible market conditions may change and the property could decline in value to the point that it isn’t a good candidate for a refinance.
Adjustable-Rate Mortgage Tips
To keep your ARM manageable, you may want to consider some of the following tips:
• Look at the rate cap structure. Make sure you can handle the monthly payment all the way to the cap rate, which is the limit on how much your interest rate will increase.
• Watch for fees or penalties. If you pay off the ARM early, you may be subject to several thousand dollars in penalties or fees. Be aware of what you could be on the hook for.
• Shop around for mortgage rates. The interest rate caps and margins will be different from lender to lender. Get a loan estimate to ensure you’re comparing apples to apples.
• Work with someone you trust. It’s incredibly valuable to work with a lender you trust to give you good advice.
The Takeaway
Many borrowers may be considering an ARM at the moment, but you still need to make sure it’s the right financial tool for you. Adjustable-rate mortgages can increase when interest rates increase and make your monthly mortgage payments unmanageable. However, it is possible that an ARM could be the right solution for buyers who don’t plan on keeping the home long-term, or for those who believe they’ll be able to refinance into a less expensive mortgage in a few years.
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FAQ
Is it ever a good idea to get an adjustable-rate mortgage?
You should get in contact with a lender if you’re wondering about whether or not an adjustable-rate mortgage is right for you. Some borrowers find it makes sense if they’re looking for financing that’s geared toward short-term situations.
What is the main downside of an adjustable-rate mortgage?
Adjustable-rate mortgages have interest rates that can rise periodically, either at 6 months or a year. You could end up with a higher mortgage payment.
What is the major risk of an ARM mortgage?
The major risk of an ARM is when it becomes unaffordable after an adjustment period. If a payment can’t be made, the risk is going down the path to foreclosure. This can happen after the introductory period ends or if an adjustment significantly raises the monthly payment.
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