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An adjustable-rate mortgage (ARM) is a home loan with an interest rate that can either increase or decrease over time, depending on market conditions. So, an adjustable-rate mortgage payment will change over time, whereas a fixed-rate mortgage is the same payment for the life of the loan. It’s a standard home loan option often compared to a fixed-rate mortgage.
Benefits and Disadvantages of an Adjustable-Rate Mortgage
The benefits of an adjustable-rate mortgage often come in the early stages of the loan and its payments. Later in the loan life, an ARM could cause you some difficulty.
|Pay lower interest rates early on
|After “teaser” rate period expires, payments may rise because or higher interest rates
|Better for short-term borrowing
|Not as stable as fixed-rate mortgages (same payment for the life of the loan)
|Lower rates can mean more money to save or invest in other things (car, vacation, etc.)
|Some may have two rate hikes in the same month
|No refinancing needed, mortgage payments will drop automatically (If rates go down)
|Loan payment structure tends to be more complicated
First and foremost, an ARM’s benefit is that your initial mortgage payments will be lower, putting more money in your pocket. This option is ideal if you’re buying a home with plans to fix it up and sell it soon after. It can be a good option if you’re looking to buy a starter home but are planning to move to a different house in a few years.
ARMs also work well if you expect your income to increase in the near future because the payments will likely be more manageable. You could also get an ARM if you plan to refinance the loan to a fixed-rate mortgage before the initial interest rate period ends.
Another bonus is if national lending interest rates were to go down, your payments could also drop.
A concern with using an ARM is changing interest rates, which can impact your budget. Many borrowers shy away from an ARM because it’s a very volatile loan, and financial uncertainty with something as pivotal to a monthly budget as a mortgage payment can be unsettling.
For example, your interest rate could go from 5.0% during your initial period to 5.25%. Sometimes, a change like that may not hit your monthly budget hard, but say, rates jump to 6.25% next year. In just over a year, you’ve jumped 1.25%, which could be hundreds of dollars from your monthly budget.
Also, ARMs can be very complicated in how they work, and if you don’t fully understand the money-borrowing process, this could be something that causes you more stress in the long run.
How Adjustable-Rate Mortgages Work
An adjustable-rate mortgage (ARM) is a loan containing a fixed interest rate for a temporary period that then shifts to one with a changing interest rate for the remainder of the loan life. Sometimes, they’re called “variable-rate mortgages” or “floating mortgages.”
You need to know the following loan components to understand how an ARM process works.
The index is a benchmark rate the lender will use. The index is based on the Secured Overnight Financing Rate (SOFR). The Federal Reserve and the U.S. Department of the Treasury set the SOFR. During the loan, the index can change.
The margin is a specific percentage lenders add to the index rate. The margin plus the index rate is how your ARM rate is determined. While margins vary among lenders, once a lender sets a margin on your ARM, it doesn’t change.
Initial Interest Rate Period
The initial interest rate period is the temporary timespan on an ARM where the interest rate is fixed. The term of this period can change, but the most common ARMs have a five-year, seven-year, or 10-year initial period.
You can tell the period’s timespan by the ARM’s name. For example, a 5/1 ARM has a five-year initial interest rate period.
Interest Adjustment Cap
With ARMs, the interest hikes you can face will be capped. The interest rate cap, or adjustment cap, is the maximum amount a rate can increase. There are usually three types of rate caps: an initial adjustment cap, a subsequent adjustment cap, and a lifetime adjustment cap.
Note: Your credit score can impact your interest rate increase following your initial rate period.
The initial adjustment cap is the highest amount a rate can go up on your loan on its first increase. The most common rate for this cap is two or five, meaning the interest rates can’t go higher than two percent or five percent immediately following the initial interest rate period.
A subsequent adjustment cap is the maximum amount the rate can go up on each following adjustment. The most common rate cap for this is usually two percent, meaning a rate can only go up a total of two percent from one year to the next.
The lifetime adjustment cap is the highest the rate can go during the life of the loan. Most of the time, the lifetime cap is 5 percent, meaning the loan interest rate can never get more than five percent higher than the initial interest rate.
However, some lenders may have higher lifetime adjustment caps, so you need to speak with a loan professional about available options.
Example: Let’s say you have a 10/1 ARM with an initial rate of 5.5%. Your ARM contains:
- An initial adjustment cap of two
- A subsequent adjustment cap of two
- A lifetime adjustment cap of five
That means the rate of interest can not be higher than 7.5% on the first adjustment, and the following adjustment can’t be higher than 9.5%, with the maximum amount of interest you can ever pay on the ARM being 10.5% since that would be five percent more than the initial rate.
Rate Change Frequency
A rate change frequency is how often the ARM can change interest rates. It can either be an annual change or a six-month change. It’s usually in the very name of the loan itself.
Example: A “5/1 ARM” is a loan with five years of fixed rates, with interest rates changing once a year for the remaining 25 years of the loan. If the interest rates were adjusted every six months, it would be a “5/6 ARM.”
» MORE: See today’s refinance rates
Type of ARMs
Most of the time, adjustable-rate mortgages come in three forms: a hybrid, an interest-only (I-O), and a payment option.
Hybrid adjustable-rate mortgages combine fixed and adjustable-rate periods. The interest rate is initially fixed, then it shifts to a variable rate at a specified time.
Two numbers usually represent the loan terms. Typically, the first number specifies the duration of the fixed-rate period, and the second shows how often the variable rate adjusts.
For instance, a 3/27 ARM has a three-year fixed rate and a variable rate for the next 27 years. A 7/1 ARM offers a seven-year fixed rate, then adjusts annually. Similarly, a 7/5 ARM maintains a fixed rate for seven years, adjusting every five years after that.
Interest-Only (I-O) ARM
An interest-only (I-O) ARM mainly means that for a specific amount of time, your payments only go toward the interest on the loan. Once that period ends, you’d pay both the loan’s interest and principal.
These ARMs are beneficial because they are initially smaller payments, keeping more money in your pocket. However, once that period ends, your payments will jump once the principal is added. Also, since you’re only paying interest, you’re not paying anything toward the principal, so you don’t have much equity built up in your home.
A payment-option ARM offers several payment choices, such as covering both principal and interest, paying only the interest, or making a minimum payment that falls short of the interest. Choosing a minimal or interest-only payment play could sound good initially.
Still, it’s important to note that this option can substantially increase your debt as interest accumulates on the unpaid principal. If you only make minimum payments, you might end up owing more than what you originally borrowed.
Refinancing an ARM
If you want to switch from an adjustable-rate mortgage, you can always refinance. There are a few reasons why refinancing your ARM is a good idea.
|Reasons to Refinance your Adjustable-Rate Mortgage (ARM)
|You can lock in a lower rate with a fixed-rate mortgage for the remainder of the loan
|You could get a better rate because of credit score increases or have more money toward a down payment
|Switching to fixed-rate mortgage would ease concerns of potential interest rate spikes
|Changing your repayment term, making your loan either a shorter- or longer-term loan
|Eliminating mortgage insurance from your current loan payment because you have built up 20% or more equity in your home
When refinancing an ARM, know there are some upfront costs you’ll have to pay.
Like your first mortgage, you’ll have to pay closing costs again on your new mortgage, typically ranging from 2% to 5% of the loan amount. If you see advertising for “no closing costs” mortgages, be prepared to pay higher interest rates.
The second is prepayment penalties. Some ARMs come with penalties if you pay off the mortgage before its original full term. Talking with a loan specialist when deciding to refinance will help you see if any such payments or penalties will affect you.
An adjustable-rate mortgage is usually a short-term play. It helps you keep more money in your pocket during the beginning of the loan, which can be perfect for someone only planning on staying in the home for a short time. They also work if you plan on refinancing before the initial period ends.
But the risks come when the interest rates start to adjust. If you’re not careful, you could find your monthly budget taking major hits if rates jump. The uncertainty can cause financial stress for you and your family, and the loan structures’ complexity can sometimes confuse borrowers.
When considering an ARM, it’s best to speak with a loan specialist who can properly review this decision’s intricacies.