Table of Contents
Current Adjustable-Rate Mortgage Rates
|3/6 ARM SOFR Purchase
|5/6 ARM SOFR Purchase
|7/6 ARM SOFR Purchase
|10/6 ARM SOFR Purchase
What is An Adjustable-Rate Mortgage?
An adjustable-rate mortgage, or ARM, is a mortgage that does not have a fixed interest rate. Instead, the mortgage rate fluctuates according to market trends for interest rates overall.
This makes adjustable-rate mortgages somewhat unpredictable. Compared to a fixed-rate mortgage, where the interest rate remains unchanged, the rate you pay may rise or fall significantly over the life of the loan.
On the other hand, adjustable mortgage rates start out significantly lower than fixed-rate mortgage rates, so you can save a lot of money if rates remain stable or decline over your mortgage term.
» MORE: See today’s refinance rates
How Do Adjustable-Rate Mortgages Work?
Adjustable-rate mortgages have established rules indicating when rates can change. Most will also have limits on how much a rate can increase at any one time and over the life of the loan. These will be specified in the loan documents and should be well understood by the borrower before closing the loan.
Rate adjustment is tied to a specific index (chosen by the lender) and influenced by a margin set by the lender. The rate adjustments are subject to caps, which limit the extent to which the interest rate can increase or decrease, safeguarding borrowers from sudden and drastic changes. Market fluctuations impact the index, leading to potential changes in the interest rate and, consequently, adjustments in the monthly mortgage payments.
Some of the more commonly used indexes that lenders use for ARM rates are:
- Treasury notes and bills
- Secondary Market Rates on Certificate of Deposits
- The Federal Costs of Funds Index (COFI) reflects the weighted average interest rate financial institutions pay for the funds they use.
Many of these indices are published in newspapers, financial websites, and online news services. Before going for an adjustable-rate mortgage, check where you can find the published adjustments, if there are any sources for rate projections, and which index the lender you are looking into uses to base their rate adjustments.
Types of Adjustable Rate Mortgages
All adjustable-rate mortgages have a preset pattern determining when the interest rate can adjust. On most home purchase or refinance loans, the initial rate is typically fixed for a period of 5 to 10 years. After this fixed period, the rate will change (per an annual or bi-annual rate) to reflect the average rate on the index the lender is using.
|Common Types of ARMs
|How They Work
|The interest rate remains fixed for the first five years and then adjusts yearly.
|The interest rate stays fixed for five years and then adjusts once every six months.
|The interest rate remains fixed for the first five years and then adjusts yearly.
|The interest rate remains fixed for the first five years and then adjusts every six months.
|The interest rate remains fixed for the first ten years and then adjusts yearly.
|The interest rate remains fixed for the first ten years and then adjusts every six months.
Note: While you can get an ARM with an initial rate that adjusts in as little as one year, 5 to 10-year initial adjustment periods are the most common.
ARM Interest Rate Cap Structure
Caps on adjustable-rate mortgages limit how much the interest rate or monthly payment can change during specific periods or over the loan’s lifetime. These caps protect borrowers from significant and sudden increases in interest rates, offering a level of predictability and security with an ARM.
There are typically three types of caps on an ARM:
- Initial Adjustment Cap: Limits the rate increase at the first adjustment after the fixed-rate period ends.
- Periodic Adjustment Cap: Limits the rate change at each subsequent adjustment (typically annually or bi-annually).
- Lifetime Cap: Sets the maximum amount the interest rate can increase over the loan’s entire term.
Let’s work through an example of a common rate cap structure on an adjustable-rate mortgage.
Let’s say you have an ARM with an initial interest rate of 3%, a 5/1 ARM (meaning the rate is fixed for the first 5 years and adjusts every year after that), and an interest rate cap structure of 2-2-5.
- The first number (2) refers to the initial adjustment cap. This means that after the initial fixed period of 5 years, the interest rate cannot increase by more than 2 percentage points at the first adjustment. So, if the initial rate is 3%, the maximum it can increase after the first adjustment is 5% (3% + 2%).
- The second number (2) is the periodic adjustment cap. After the first adjustment, for subsequent adjustments, the interest rate cannot increase by more than 2 percentage points from the previous adjusted rate. This cap will limit how much the rate can change each adjustment period.
- The third number (5) is the lifetime cap. Over the life of the loan, regardless of the adjustment periods, the interest rate cannot exceed more than 5 percentage points from the initial rate. If the initial rate is 3%, the maximum lifetime rate would be 8% (3% + 5%).
Pros and Cons of an Adjustable Rate Mortgage
Choosing between an ARM and a fixed-rate mortgage often depends on your unique financial situation, how long you plan to stay in the home, risk tolerance, and ability to handle potential payment increases.
Advantages of Adjustable Rate Mortgages
- Lower Initial Rates: ARMs often start with lower initial interest rates compared to fixed-rate mortgages.
- Potential for Lower Payments: If interest rates remain stable or decrease, borrowers may benefit from lower monthly payments during the fixed-rate period or subsequent adjustments.
- Short-Term Planning: Ideal for those who plan to relocate or sell their home before the initial fixed-rate period ends. They can take advantage of the lower rates without experiencing the adjustable rate period.
Disadvantages of Adjustable Rate Mortgages
- Rate Volatility: Rates can fluctuate after the initial fixed period, leading to potential increases in monthly payments.
- Risk of Higher Payments: If interest rates rise significantly after the fixed period, borrowers might unexpectedly face substantially higher monthly payments.
- Uncertainty: ARMs carry an element of uncertainty as future rate adjustments depend on market conditions, making it harder to predict long-term housing expenses.
- Potential for Negative Equity: If rates rise sharply, the property’s value might not increase at the same rate, leading to a situation where borrowers owe more than the home is worth (known as being “underwater”).
In a scenario where the market value of your home falls below the outstanding mortgage balance, options like refinancing become limited due to lenders often requiring a certain level of equity. Selling the property also becomes complex; the sale proceeds might not cover the remaining mortgage debt, leaving you with a deficit. This situation can trap homeowners, making it challenging to move or sell without bringing in additional funds to cover the shortfall.
This is why it’s vital to monitor market conditions so that you can sell or refinance to a fixed-rate mortgage if you anticipate rates rising at the end of your initial rate period.
Is An Adjustable-Rate Mortgage A Good Idea?
It goes without saying that interest rates can go up or down. Therefore, this type of mortgage loan would be best for people who are not too sensitive to fluctuating financing costs.
ARMs can be especially beneficial for the following types of borrowers:
- Short-Term Homeowners: Individuals planning to sell or refinance within the initial fixed-rate period can benefit from the lower initial rates without experiencing potential adjustments.
- Those Expecting Rate Decreases: Borrowers who anticipate falling interest rates in the near future might find ARMs attractive. They can take advantage of the initial lower rates and potentially benefit from subsequent drops.
- Buyers in Strong Financial Standing: Borrowers with strong financial stability and can absorb potential payment increases if rates rise may find ARMs suitable. This includes those with higher incomes or assets who can handle fluctuating payments.
- Military Personnel or Frequent Relocators: Those in professions requiring frequent moves or deployments might opt for ARMs due to the likelihood of selling or relocating before the adjustment period begins.
It’s important to consider personal financial situations, long-term housing plans, and the potential risks of fluctuating interest rates before choosing an ARM. Consulting with a financial advisor or mortgage professional can help you make an informed decision.