Most buyers get a loan when purchasing a new home or investment property. Fixed-rate 15 or 30-year mortgages are the most common type of conventional loan. However, there are several other types of loans that home buyers can secure, such as adjustable-rate mortgages (ARMs).
Unlike a fixed-interest-rate mortgage that stays the same over the life of a loan, the rate on an ARM changes throughout the loan’s life.
In addition, adjustable-rate mortgages have some critical differences from other loans that borrowers should fully understand before securing.
“They are a solid loan product, but they are not for everyone,” says Kelly Zitlow, the Senior Mortgage Advisor and EVP of Sales and Marketing for Cornerstone Home Lending in Scottsdale, Arizona.
Key Takeaways:
- Adjustable-rate mortgages usually feature a low interest rate for an introductory period, resulting in lower monthly payments at the beginning of the loan.
- After the introductory period the interest rate will adjust at specific times, typically yearly or every six months.
- An ARM makes the most sense for homebuyers who plan to sell their home or refinance before the introductory period ends.
How ARMs Work
An ARM is a variable rate mortgage where the interest rate adjusts at predetermined periods.
The beginning of the loan typically has an introductory rate period where the interest rate stays the same. This initial fixed-rate period can be two, three, five, seven or 10 years, depending on the type of ARM you get.
After the introductory period ends, the interest rate adjusts according to the benchmark index outlined in the mortgage agreement, with an added margin. The margin is an additional percentage the bank charges on top of the benchmark index rate.
The margin is different for every borrower and is based on credit score, down payment amount and credit risk. However, the typical range is 1.75% to 3.5%. For example, if the benchmark index is 6.2% and your margin is 2%, your interest rate will be 8.2% at the adjustment period.
If the index rate is lower than your current rate, it will decrease your monthly mortgage payments until the next adjustment period. Similarly, if rates are higher, your payment will increase until the next adjustment.
How ARM Rates Are Determined
Most ARM loans use the Secured Overnight Financing Rate (SOFR) benchmark index, which replaced the London Interbank Offered Rate (LIBOR) in 2020.
Adjustment Periods for ARM Rates
ARM rates normally adjust in six-month or one-year increments after the introductory period, but the adjustment periods can be longer depending on the loan terms.
You can see how often the rate will adjust by looking at the second number in the ARM loan type. For example, a 5/6 ARM will have an initial fixed-rate period of five years then adjust every six months after.
How ARM Interest Rate Increases Are Managed
Normally, there is a maximum rate your loan can change, which is called an interest rate cap.
Cap limits keep your mortgage payment from going beyond a reasonable increase or decrease and make the adjustment periods more manageable for the borrower.
Initial Adjustment Cap
The initial adjustment cap limits your first increase after the introductory period. After that, there may be a set cap for each interest rate adjustment following your ARM schedule. If the adjustment cap is two, your rate can’t jump more than 2% during a single change.
Lifetime Cap
The lifetime cap stops the loan from increasing or decreasing by a certain percentage over the life of the loan. The lifetime cap can be as little as 5% or as high as 12%, meaning your rate can never increase or decrease beyond that percentage.
Advantages of an Adjustable-Rate Mortgage
One of the biggest advantages of an adjustable-rate mortgage is lower introductory rates. During the fixed-interest period, you typically receive a much lower rate than you would get with a fixed-interest loan. This usually means lower payments at the start of your loan.
If rates increase when your loan is set to adjust, you can preemptively refinance or sell the home before the adjustment takes place. This makes an ARM a great option if you have shorter homeownership plans and don’t intend to own the home for more than the introductory period. It can also work well for individuals who know they will have a higher income in the future.
Disadvantages of an Adjustable-Rate Mortgage
The disadvantage of an adjustable-rate mortgage is that your mortgage payment will change. This change can lower your payment, but it can also increase it substantially over the life of the loan.
Borrowers with a set income or budget may not be able to afford a higher payment in the future if rates increase.
ARM loans were incredibly popular before the Great Recession and were a catalyst in the housing crisis from 2008 to 2011. Many long-term homeowners didn’t fully understand how high their mortgage could become, and when their rates adjusted they were unable to pay their mortgages.
Types of ARMs
Most ARMs are hybrid loans, which means that they have a fixed-rate period and an adjustable interest-rate period. Usually, they are 30-year loans that are amortized (paid off) on a 30-year time schedule.
“There are ARM loans that are not hybrid, that adjust every month but they are not very popular,” says Zitlow. Below are the most popular adjustable-rate mortgages today.
Factors to Consider When Choosing an ARM
Zitlow says it’s crucial to look at the spread between the 30-year fixed-rate and 5-year ARM loan to assess if this type of loan is even worth it.
“If you’re getting a full point and interest rate better than a fixed-rate loan, it could be something to consider if you are in a position to be able to make your payment when your rate adjusts,” Zitlow says.
Interest rates are constantly changing. While this can be beneficial in a low interest rate environment, historically you will experience increases more than rate decreases.
Potential Risks of an Adjustable-Rate Mortgage
If you’re relying on refinancing or selling before the loan adjusts, there’s no way to predict if the market will allow you to do that successfully. You need to maintain a good credit score and a low debt-to-income ratio to qualify for a new loan, which may have much higher rates at that time.
The market doesn’t always go up either. If you didn’t gain much equity in the fixed-rate period, you could be left underwater when it's time to sell.
When Does an ARM Make Sense?
If you believe you will be in the home for a short period, are comfortable with the potential rate adjustment and can afford the potential increase, then an ARM loan could be a good fit for you.
Just know all of the features, not just if it's fixed for a period of time or not, says Zitlow. “You want to know when it adjusts, the benchmark it's tied to and if there is a cap on it. Your rate can go up as much as 5% on the first adjustment, which is the biggest risk you need to assess if it's right for you or not. It can help you predict your future exposure.”
The Bottom Line on Adjustable-Rate Mortgages
An adjustable-rate mortgage is more complicated than a traditional fixed-rate loan. It’s not likely to be a good loan option if the potential for higher monthly payments would cause a financial burden. However, for the right borrower, an ARM can be a way to save money with a lower interest rate for a short period. This allows the borrower to take advantage of a lower payment in low-interest rate environments.
If you're considering an ARM, consult your lender and your real estate agent to determine if this type of loan is the right choice for you. Ensure you can afford a potential increase and fully understand the terms, including the potential rate hikes you can experience over the life of the loan before signing.