Adjustable-Rate Mortgage

How it Works

An ARM mortgage is a home loan that allows borrowers to make smaller payments during an initial fixed-rate period. Adjustable-rate mortgages are popular amongst those who are mobile and plan to move before the end of the introductory fixed-rate period. You may also consider an ARM mortgage if you expect a raise or increase in income down the road.

This loan option is unique because the rate fluctuates or adjusts after the preliminary fixed-rate period. If you are thinking about owning your home for only a few years or expecting your income to grow in the future, an ARM could be worth exploring if a fixed-rate mortgage rate proves to be too high. While you have several options, the most standard ARM mortgage is the five-year ARM, where the initial fixed rate stays the same before the first adjustment.

Know that you have options and that a trusted lender can help you determine whether an ARM could be a viable solution for you.

The pros and cons of an ARM

An ARM mortgage has advantages and disadvantages. It’s important to understand the ins and outs of this loan program before assuming it’s the right home loan in your situation. The last thing you want to do is buy a home using an ARM mortgage, only to realize that you made the wrong choice years later.

Pros

• Lower interest rates than fixed-rate mortgages
Whether you opt for a 3-year, 5-year, 7-year, or 10-year ARM loan, you could be looking at significant savings. You can benefit from an even lower rate, making it possible to afford a larger home. Think of it this way: a 5-year ARM translates to five years of ultra-low monthly payments. Borrowers can use the extra funds to pay off debt, renovate, or save for their next home.
• Greater flexibility if you plan to move within a few years
Think about what the future could hold. Maybe it’s moving closer to family or across the country for work. Whatever the case, you don’t intend to stay in this house for a long time. An ARM mortgage provides the flexibility of a low-rate home loan before you make your next move.
• The chance for even lower payments
Borrowers already benefit from a low rate with an ARM loan. But who’s to say they won’t drop lower once your fixed-rate period ends? You never know what could happen to the market in a few years, making lower interest rates and monthly payments possible.

Cons

• The chance of higher rates and payments
It’s impossible to predict how interest rates might change in a few weeks, let alone several years. Selecting an ARM mortgage means putting yourself at risk of a higher rate and, in turn, higher payment once the initial fixed-rate period ends. This lack of predictability could be challenging for many borrowers, especially those who aren’t expecting a sizable pay increase anytime soon.
• Uncertainty with payments
This drawback ties back to the previous point. Ask yourself if you want to deal with a mortgage payment that’s constantly changing. Since your home loan is likely your largest expense, you probably don’t want it fluctuating on multiple occasions. On the other hand, a fixed-rate loan stays the same over the life of the loan.
• Uncertainty with your financial situation
Those who choose an ARM mortgage typically do so because they see themselves making more money when their interest rate adjusts. But what happens if things are different than what you envisioned? You could be let go from your once stable job and have to take a lesser paying job until you find something else. Or perhaps your spouse will experience some health challenges that keep them from working full-time. It all comes down to accepting this risk and preparing your household for a potentially larger expense, regardless of other circumstances.

Types of ARMs

Prospective buyers can choose from several different types of ARM mortgage options. You’ll find in your research that these loans come with numbers in front of them. For example, your lender might present a 5/1 ARM, 10/1 ARM, or 7/6 ARM.

The first number signifies the duration of the fixed period. The second number tells you the frequency of a rate change. Let’s look at the types of ARMs one by one.

This loan program has a fixed rate for the first five years before adjusting every year for the remaining 25 years. Many buyers lean toward a 5/1 ARM if they see their home purchase as a short-term move. Of the different ARM types available, this one arguably provides the most flexibility for borrowers.

A 10/1 ARM mortgage has a fixed interest rate for the first ten years of the term. Once this period ends, borrowers must plan for the rate to change every year for the remaining 20 years. You might consider this option if you’d like greater stability with your mortgage payment but still want the benefit of an incredibly low rate.

Like a 10/1 ARM, a 10/6 ARM mortgage has a rate that stays the same for the first ten years. However, the difference is that the rate adjusts once every six months for the rest of the term with a 10/6 loan.

Would you rather your rate not adjust at year five or ten? Then you might consider a 7/6 ARM. You’ll have a fixed rate for seven years before the rate changes every six months over the final 23 years. A 7/6 ARM and 10/6 ARM are often riskier than other ARMs due to the frequency of potential rate adjustments.

Adjustable-rate vs. fixed-rate mortgages

ARM mortgages are considered risky because of potential interest rate hikes after your fixed-rate period ends. Receiving a more competitive rate for a few years could help you afford a more expensive home. Just be sure to understand you may be susceptible to an adjustment increase after that.

The adjustments are based on a set of indexes defined in the loan agreement. When the time comes to adjust the rate, the lender adds a margin to the current index value to calculate the borrower’s new interest rate. Additionally, borrowers are protected by industry caps, which limit the frequency of change, the periodic change from one adjustment to another, and the total change in interest rate over the loan’s duration.

You don’t have to worry about margins, rate caps, or rate adjustments with a fixed-rate mortgage. The interest rate never changes, ensuring you can focus on the same monthly payment from the first year to the last.

Now, if you select an ARM when you buy a home and know it’s about to adjust and increase, know that you have the option to refinance. Whether you move forward with a conventional loan, ARM mortgage, or one of the many government programs, complete your research and know that you always have the best rate and terms. Doing so could save you hundreds a month, plus tens of thousands in the long run.

Questions to ask yourself about ARM loans

• Will my income increase enough to cover higher mortgage payments if interest rates go up?

  If the answer is yes, an ARM mortgage could be a sensible choice.

• Will I be incurring other sizable debts, such as a loan for a car or school tuition, soon?

  Since you could be responsible for higher payments once your interest rate increases, you may want to avoid taking on other debt. You may want to eliminate as much debt as possible before buying a home.

• How long do I plan to own this home?

  An ARM might not be the best choice for those looking to finance a long-term or forever home. It’s critical to decide when you plan to move and whether you’ll be elsewhere before the fixed-rate period ends.

• Can my payments increase even if interest rates generally do not increase?

  Even if you’re buying a home in an environment where rates are relatively stable, things can quickly change. Global news, economic news, the Federal Reserve, loan program type, and individual risk factors influence a consumer mortgage rate.