What Is An Adjustable-Rate Mortgage?
No two home buyers are the same. People have different financial goals and different plans for the future. Luckily, lenders don’t use a one-size-fits-all approach with mortgages. Instead, they offer various loan options so each buyer can find the one that best suits their needs. Several factors – including the desired loan amount and loan term – can help you determine the right fit for your situation.
For example, a fixed-rate loan may be good for those who want to plant their roots and have a predictable interest rate that never changes. But for those who are purchasing a starter home or have a lifestyle of constant change, buying a home with an adjustable-rate mortgage or refinancing to an adjustable-rate mortgage (otherwise known as an ARM) may better meet their needs. Let’s take a look at how ARM loans work so you can make the right choice for your home purchase.
Adjustable-Rate Mortgage Definition
An adjustable-rate mortgage is a home loan with an interest rate that changes over time based on market conditions. With a 30-year term, an ARM’s initial rate is fixed for a specified number of years at the beginning of the loan term and then fluctuates for the remainder of the term.
The interest rate can adjust every month, quarter or year depending on the terms of the loan. With each rate change, your monthly payment will change, too.
If interest rates fall, your ARM loan will likely adjust to a lower interest rate than you had initially. However, if interest rates increase, the ARM loan will likely switch to a higher rate that increases your monthly mortgage payment.
Adjustable-Rate Mortgage (ARM) Terminology
Before you can fully understand how ARM mortgages work, you need to understand the terminology commonly used when discussing them.
A variable interest rate, also known as an adjustable or floating rate, varies over time. This means the interest rate is different throughout the lifespan of a loan. The fluctuation is due to variations in the index, which acts as the rate’s benchmark.
Indexes For Adjustable-Rate Mortgages
Indexes are economic indicators used to calculate interest rate adjustments for adjustable-rate mortgages. The ARM loan’s index rate can increase or decrease anytime. These changes are measured in basis points, which are a special unit used for financial indexes.
Some of the most used indexes are:
- Secured Overnight Financing Rate (SOFR): Formerly the broad Treasuries financing rate, this index is the successor to LIBOR, short for the London Interbank Offered Rate. It measures the cost of borrowing cash on an overnight basis, but to keep it simple, just know it’s a major factor in determining your variable rate at any given time.
- Constant maturity Treasury index: The 1-year constant maturity Treasury index is the most widely used in determining adjustments to the adjustable-rate mortgage interest rate. The value is derived from risk-free securities called Treasuries.
- 11th District Cost of Funds Index (COFI): COFI is an index that reflects the average interest rate that the 11th Federal Home Loan Bank District pays for checking and savings accounts.
Adjustable-Rate Mortgage Margin
Margin is a percentage point predetermined by your lender that remains the same throughout the life of the loan. It’s used to determine the interest rate for loans. Once the initial fixed-rate period ends on an adjustable-rate mortgage, the interest rate typically adjusts annually, and this new rate is determined by adding the index to the margin.
Although this may cause the interest rate to increase, certain caps limit how much it can increase.
Adjustable Interest Rate Caps
- Initial cap: This is the maximum amount the interest rate can adjust the first time it’s changed after the fixed-rate period.
- Periodic cap: This puts a limit on the interest rate increase from one adjustment period to the next. The initial cap and the periodic cap may be the same or different.
- Lifetime cap or ceiling: This puts a limit on the interest rate increase or decrease over the lifetime of the loan, and all adjustable-rate mortgages have a lifetime cap. Although these limits are put in place for rate increases, rates can also decrease. However, since the margin stays the same throughout the life of the loan and is added to the index to get the interest rate, the rate will never fall below the margin.
Adjustable-Rate Mortgage Cap Structure
The cap structure is a numerical representation of each cap for the loan. This is presented in a series of three numbers that represent the three caps: initial cap, periodic cap and lifetime cap.
For example, a common rate cap is 2/1/5, which breaks down like this:
- Initial cap: Your initial interest rate can only change by up to 2% the first time it adjusts.
- Periodic cap: Each change after that is limited to 1% every 6 months.
- Lifetime cap: Throughout the rest of the loan term, the most the interest rate can increase or decrease is 5% from the fixed rate. So, if your original rate was 3.5%, your interest rate can only go up to 8.5% during the life of your loan.
Different Types Of Adjustable-Rate Mortgages
There are several types of adjustable-rate mortgages, and they’re often represented numerically (for example, 7/6 or 10/6). The first number indicates how long your fixed-rate period will last. The second number indicates how often the rate will change. Some of the most common ARM loans include:
- 5/1 ARM: A 5/1 ARM loan has a fixed rate of interest for the first 5 years of the loan. After that, the interest rate will adjust annually for the remaining 25 years.
- 10/1 ARM: A 10/1 ARM loan has a fixed rate of interest for the first 10 years of the loan. After that, the interest rate will adjust annually over the remaining 20 years.
- 5/6 ARM: A 5/6 ARM loan has a fixed interest rate for the first 5 years of the loan. After that, the rate adjusts every 6 months for the remaining 25 years.
- 7/6 ARM: A 7/6 ARM loan has a fixed rate of interest for the first 7 years of the loan. After that, the interest rate will adjust once every 6 months over the remaining 23 years.
- 10/6 ARM: A 10/6 ARM loan has a fixed rate of interest for the first 10 years of the loan. After that, the interest rate will adjust once every 6 months for the remaining 20 years.
Other Types Of Adjustable-Rate Mortgages
As long as lenders meet federal lending laws, they have some flexibility with how they structure their ARM loans.
Though most lenders offer standard hybrid adjustable-rate mortgages with a fixed interest rate for a set number of years, these loans aren’t the only option. The two types of ARM home loans described next are also available for borrowers to consider.
- Interest-only ARMs: Interest-only ARM loans allow borrowers to make payments toward the loan’s interest – rather than interest and principal – for a set period of time. Once that time elapses, borrowers must start making payments toward both the interest and the loan’s principal.
- Payment option ARMs: Payment option adjustable-rate mortgages allow borrowers to select a particular repayment term based on their financial situation and budget. Borrowers can choose between interest-only payments, principal and interest payments, and minimum payments.
Keep in mind that these types of adjustable-rate mortgages can be risky since your payments may not be large enough to start paying anything toward the principal loan balance. This puts borrowers at an increased risk of defaulting on the loan. It’s important to note that many mortgage lenders won’t issue interest-only or payment option ARMs.
Choosing The Right Adjustable-Rate Mortgage For You
With several types of adjustable-rate mortgages available for consideration, how do you know which one to choose? You’ll need to carefully think about how each type will impact your financial health. Here are a few questions to ask yourself before applying:
- How long do I plan to stay in my home? If you intend to remain in your home for more than 10 years, a conventional mortgage with a fixed interest rate will likely be the best choice. However, if you plan on moving in a few years, an ARM loan may help you get a lower interest rate.
- Do I expect any big life events in the next 5 – 10 years? Getting married, having kids and starting a new job can impact your finances and your ability to make higher monthly payments.
- Do I need time to comfortably afford a larger monthly payment? Adjustable-rate mortgages often have lower initial monthly payments, giving you the time you need to build your savings and increase your income to afford higher monthly payments.
- Is my income unstable or going to be unpredictable in the next few years? ARM loans are typically easier to qualify for, especially if your income is prone to change.
- What adjustable-rate mortgage options does my lender offer? Some lenders may not offer adjustable-rate loans, and some may only offer loans with terms that don’t fit your budget.
The biggest difference between an ARM and a fixed-rate mortgage is that one has an interest rate that changes, while the other has an interest rate that stays the same throughout the life of the loan. But there are a few additional differences, including:
- Fixed-rate loans are most often offered with terms of 15 or 30 years, although there are some custom-rate terms. ARM loans typically have 30-year terms.
- Your starting rate may be lower for an ARM loan than a fixed-rate mortgage.
- Your monthly mortgage payment may be more affordable in the first few years of an ARM loan.
- The minimum down payment for an adjustable-rate conventional mortgage is typically 5%, whereas the minimum down payment for a fixed-rate conventional mortgage can be as low as 3%.
Advantages Of An Adjustable-Rate Mortgage
The biggest advantage of an adjustable-rate mortgage is the initial terms, which can provide you with a lower initial rate and monthly payment than a fixed-rate loan. Other advantages of an ARM loan include:
- Savings if you sell: If you plan to move or sell your house within a few years, you can reap the benefits of a low rate and sell the home before the rate adjusts.
- Interest rates that may drop: Remember, interest rates can go up and down, and if mortgage interest rates fall, you could end up with an even lower monthly payment than you had before.
- No need to refinance: If rates do fall, you can reap the benefits without having to deal with the costs or paperwork of a refinance.
Disadvantages Of An Adjustable-Rate Mortgage
Due to the adjustable-rate nature of an ARM, these possible disadvantages of this option are worth considering:
- Prepayment penalties: Often, ARMs impose penalties if you sell or refinance the loan within the first 5 years of getting your mortgage. For this reason, it’s important to either find an ARM without these penalties or keep your mortgage beyond the penalty period.
- Payment increases: Once you get beyond the fixed-rate period of your ARM, the rate of interest can rapidly and substantially increase, thus raising your monthly payments. In some situations, making the payment can become more difficult.
- Complicated structure: ARMs are complex and can therefore be hard to understand, which can complicate matters for a home buyer whether it be due to structures, fees or other factors.
Considerations When Choosing An ARM Loan
When deciding whether to choose an adjustable-rate mortgage, take these other factors into account:
- Unexpected changes: You may plan to move or sell your home within a few years, but the unexpected could arise, leaving you unable to sell the home as originally planned. This, in turn, could mean that you’ll be stuck with a higher interest rate than you bargained for. Make sure you’re able to cover a potentially much higher payment before you apply.
- Rising rates: Although your interest rate could go down, it could also rise during your loan term. If your interest rate increases, you’ll have a higher monthly payment. Always save money to account for the possibility of higher rates.
- Prepayment penalty: Some ARMs have a prepayment penalty. Speak with your lender and be sure you understand the terms of the loan before moving forward.
Frequently Asked Questions
Now that you know what an ARM is and how it works, you’ll be able to better determine whether it’s the right loan option for you. Next are some of the most frequently asked questions about adjustable-rate mortgages.
When does an adjustable-rate mortgage make sense?
It can make more sense to get an adjustable-rate mortgage when interest rates are on the rise, as long as you plan on moving before your rate adjusts. Why? Because when interest rates are rising, the difference between fixed and adjustable rates tends to be more pronounced.
If fixed rates are on the rise, the rate during the initial fixed period for an ARM loan could be much lower compared to a conventional 30-year fixed-rate mortgage than if fixed rates were lower.
Can I take advantage of the fixed-rate period?
If you’re able to make extra mortgage payments toward the principal balance during the fixed, low-rate period of your adjustable-rate mortgage, you could pay down more of your principal balance. This could save you more money on interest in the long run, which could keep payments low when your interest rate adjusts.
Does how long I plan to live in the home matter?
Yes. An adjustable-rate mortgage is an excellent option if you relocate frequently or you’re buying a starter home and plan on moving into a bigger house within the next 5 years. Committing to a 30-year fixed-rate mortgage won’t grant you the same flexibility as an adjustable-rate mortgage. With an ARM loan, you could take advantage of the lower rate today with the knowledge that you’ll be moving before it adjusts to a potentially higher interest rate.
Are ARM loans only good for home purchases?
No. An adjustable-rate mortgage could also make more financial sense than a fixed-rate mortgage if you’re considering refinancing your mortgage.
Keep in mind that there’s risk involved – interest rates are always shifting, after all – so carefully weigh your options. If you plan on staying in the home long term, be prepared to handle the higher payments that will likely come if your rate increases.
The Bottom Line
Although ARMs may not be the right choice for everyone, their initially low interest rates and convenience for short-term homeowners make them an option worth pondering. Look at your financial situation and factor in all the pros and cons of adjustable-rate mortgages before you apply.
If you’re ready to take the next step in your search for a loan, start the mortgage approval process online.