What Is An Adjustable-Rate Mortgage?
An adjustable-rate mortgage (ARM), or variable-rate mortgage, is a loan type with an interest rate that varies throughout the loan’s life. Adjustable-rate mortgages feature a fixed rate initially and then a variable interest rate that resets in predetermined periods, such as monthly or annually. ARM interest rates are set using indexes and an ARM margin. There are pros and cons, plus a lot to learn, about ARMs. We’ll review all that and more later in this article.
What’s important to understand first is that 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 when it comes to mortgages. Instead, they offer different loan options to better suit each buyer’s needs. Many factors determine the best bet for your situation, including the loan amount, desired period of time and more.
For example, a fixed-rate loan may be good for those who want to plant their roots and have the reliability of an interest rate that never changes. But for those who are purchasing a starter home or have a lifestyle of constant change, buying your home with or refinancing to an adjustable-rate mortgage (or ARM loan) may better meet their needs. Read on to decide whether an ARM is right for you.
How Does An Adjustable-Rate Mortgage Work?
As discussed above, an adjustable-rate mortgage is a home loan with an interest rate that adjusts 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 adjusts for the remainder of the term.
Before we can discuss ARM loans, there are a few terms to understand.
Adjustable-Rate Mortgage (ARM) Terminology
A variable interest rate, also known as an adjustable or floating rate, varies over time. This means that 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 at any time. These changes are measured in basis points, which is a special unit used for financial indexes.
As of this writing, the most-used indexes are:
- Secured Overnight Financing Rate (SOFR): Formerly the broad Treasuries financing rate, this index is the successor to LIBOR. 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: 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): 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 term 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, there are caps on how much it can increase.
Adjustable Interest Rate Caps
- Initial cap: The maximum amount that the interest rate can adjust the first time it’s changed after the fixed 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 life of the loan, and all adjustable-rate mortgages have a lifetime cap. Although these limits are put in place for rate increases, rates can decrease, too. 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
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 different types of adjustable-rate mortgages, and they are 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 over 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. At this time, Rocket Mortgage® doesn't offer 10/1 ARMs.
- 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 over 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 over 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. For example, there are some lenders who offer a 1/1 ARM loan, which has a fixed-rate term of just 1 year. We don't offer this type of ARM.
Choosing The Right Adjustable-Rate Mortgage For You
With so many types of adjustable-rate mortgages, how do you know which one to choose? Here are a few questions to ask yourself:
- How long do you plan to stay in your home?
- Do you expect any big life events in the next 5 – 10 years (like marriage, children, new job)?
- Do you need time to comfortably afford a larger monthly payment? How much time?
- Is your income unstable or going to be unpredictable in the next few years?
- What adjustable-rate mortgage options does your lender offer?
Adjustable-Rate Mortgage Examples
If you plan on living in your home for less than 10 years, a 7/6 ARM loan may be a good option for you.
If you plan on living in the home long-term or need extra time to create a firm financial footing, a 10/6 may be a better choice.
When deciding which mortgage is right for you, discuss your plans with your home loan expert, who can make recommendations based on your individual goals and needs.
Adjustable-Rate Mortgage Vs. Fixed-Rate Mortgage
The biggest difference between an ARM and a fixed-rate mortgage is that one has an interest rate that changes, and one 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 offered as terms of 15 or 30 years, although there are also custom rate terms as well. ARM loans are typically 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 mortgage is 5%, whereas the minimum down payment for a fixed-rate mortgage can be as low as 3%, depending on the loan.
Like any loan, there are advantages to ARMs, as well as some important considerations to make.
Advantages Of An Adjustable-Rate Mortgage
The biggest advantage of an adjustable-rate mortgage is the initial fixed-rate term, which can provide you with a lower initial rate and monthly payment than other loans – even when compared to a fixed-rate loan. Some other advantages of an ARM loan include:
- If you plan to move or sell your house within a few years, you can reap the benefits of a low fixed rate and sell the home before the rate adjusts.
- Remember, interest rates can go up and down, and if mortgage interest rates fall, you could get an even lower monthly payment than you had before.
- If rates do fall, you’ll be able to reap the benefits without having to go through the costs or paperwork of a refinance.
Disadvantages Of An Adjustable-Rate Mortgage
Due to the adjustable rate nature of an ARM, there are some possible disadvantages to consider.
- Prepayment penalties: Often, ARMs impose penalties should 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 plan to stick with 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 increasing your monthly payments. In some situations, making the payment can become more difficult.
- Complicated: The fact is that ARMs have a host of complexities that can be hard to understand, which can make things difficult should you not understand them fully. This includes structures, fees and 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 when you want – or some life event could keep you from moving as originally planned. This, in turn, could mean that your rates aren’t what you expected.
- Rising rates: Although your interest rate could go down, it could also rise during the life of your ARM loan. If your interest rate increases, you’ll have a higher monthly payment. Make sure you’re saving money for the possibility of higher rates.
- Prepayment penalty: Some ARMs may have a prepayment penalty. Speak to your lender and make sure you understand the terms of the loan before you move forward (Rocket Mortgage® does not have any prepayment penalties).
Read more: 7/6 ARM: Definition And How It Works
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. Here are some questions to ask yourself as you decide on a mortgage loan:
What’s the current interest rate environment?
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, there tends to be a more pronounced difference between fixed and adjustable rates.
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 it would be 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 does adjust.
Does how long I plan to live in the home matter?
Yes. An adjustable-rate mortgage is an excellent option if you’re buying a starter home and plan on moving into a bigger house within the next 5 years. Or, if you relocate frequently, 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 low rate today with the knowledge that you’ll be moving before it adjusts to a different interest rate.
An adjustable-rate mortgage could make more financial sense than a fixed-rate mortgage for your home loan if interest rates are on the rise. That goes for both first-time home buyers and savvy mortgage loan refinancers.
Keep in mind that there’s risk involved – interest rates are always shifting, after all – and make sure you consider your options. If you plan on staying in the home long-term, make sure you’re able to handle the financial changes that may come if your rate increases.
The Bottom Line
Although ARMs may not be the right choice for everyone, their starting low interest rates and convenience for short-term homeowners make them an option worth considering for some.
If you’re ready to take the next step in your search for a loan, you can get started with your mortgage approval online.