What Is an Adjustable Rate Mortgage?Updated January 9, 2023 Home Loans
If you’re interested in buying a home, you most likely need to secure a mortgage loan from a financial institution like a bank, credit union, or mortgage company. Most borrowers spend years preparing for this by saving up for a down payment and increasing their credit score in hopes of getting the lowest interest rate available. There are several types of home loans available, such as a fixed rate mortgage, interest only mortgage, jumbo loan, reverse mortgage, and adjustable rate mortgage.
An adjustable rate mortgage (ARM) is a popular type of home loan that may be preferable under certain circumstances.
Pros and Cons of Adjustable Rate Mortgage
Pros of an Adjustable Rate Mortgage
- Lower Initial Payments
- Save Interest in the Short Term
- Payment Caps
- Adjusted Rates Could Decrease Payments
Cons of an Adjustable Rate Mortgage
- Risk of Payment Increases
- Financial Circumstances Change
- Possible Prepayment Penalties
An adjustable mortgage rate isn’t the best option for everyone, which is why you should take time before you meet with a loan officer to educate yourself on the pros and cons of an ARM loan. The type of loan you choose will affect your mortgage payment, what your monthly interest payment will be, and it will stipulate the terms of your loan. And while an ARM loan and a fixed-rate loan may look somewhat similar on paper, there are some key distinctions you should know about.
What Is an Adjustable Mortgage?
Adjustable rate mortgages are home loans that do not have a fixed interest rate. Instead, your interest rate will be set at a certain percentage for a preliminary period, but will then fluctuate at set intervals throughout the life of the loan in response to market conditions. The length of this introductory period (known as your rate lock period) will depend on the terms of your loan but the most common are three years, five years, and 10 years.
ARM loans will also differ in how often your rate will change after your initial rate lock period. Some will change each year afterward the initial period, while others may change every six months. For example, a 7/1 ARM would have a fixed interest rate for the first seven years, then change every year after that. Or, a 10/6 ARM would have the same rate for the first 10 years, then fluctuate every six months after the 10 years are up.
How Does an Adjustable Rate Mortgage Work?
When you’re approved for an ARM loan, you’ll start out with a fixed initial interest rate that you’ll keep for three, five, seven, or 10 years. After this time period is over, your ARM rate will change each year, or every six months in some cases. Notably, your rate may go down or up since it’s tied to an index that tracks market conditions. Therefore, if rates in the market are generally low, your new annual percentage rate (APR) will be low. Conversely, if market rates are higher, your APR will be higher.
Because no one can predict what the market will be doing several years down the line, ARMs can be risky. You only want to work with the best mortgage lenders in the business and you should never sign off on an ARM loan with someone who isn’t able to answer all your questions and thoroughly explain the structure of the loan. That said, people take out ARM loans every day knowing the interest rate change is largely out of their hands. If you plan your personal finances correctly and fully understand what you’re getting into, an ARM loan could be a wise financial decision.
Pros of an Adjustable Rate Mortgage
Why choose an adjustable rate mortgage?
Lower Initial Payments
One of the biggest advantages of going with an adjustable vs fixed rate mortgage is that you can often get a much lower interest rate for the first period. And, although your total monthly payment may be larger than it would be for a 30-year home loan since you have fewer months to cover the principal balance, many borrowers value the lower payments they can count on during this initial fixed rate period. If you only plan on keeping the house for a few years, locking in a lower rate can give you predictable payments for the first three, five, or seven years. And, because you’ll be putting more money toward your loan balance each month and less toward interest, when you do sell, you’ll have built up more home equity.
Save Interest in the Short Term
This initial rate you get with an ARM is almost always lower than a 30-year fixed, and you can save thousands of dollars on interest during this time. Although rates will vary based on market conditions, you can often save an entire point or more by going with an ARM. However, these ultra low rates are reserved for those with a high credit score and those who can make a larger down payment, but this is true of any type of loan, not just an ARM.
For those who might be wary of the unpredictable nature of a changing mortgage rate, ARMs do also come with something called a “floor cap” and “payment cap” which limits how much your rates can change over the life of the loan. You may be able to find a cap at around one point, which means your interest rate can’t go up more than one percentage point after your initial period, regardless of what the market is doing. However, rates will vary by lender and the terms of your loan.
However, most floors and caps are structured so that you have one cap after your preliminary period, one cap for the subsequent periods, and one cap that applies to the life of the loan. For instance, you may agree to a 3/1/5 cap structure. In this example, your interest rate can’t go up by more than three points after your initial period is over, can’t go up by more than one point for each adjustment period afterward, and can never go over five points from your original rate over the life of the loan. Knowing this interest rate cap right from the start can help you plan for a worst-case scenario, and gives you an idea of what your future payments could look like for the remaining term of the loan.
Adjusted Rates Could Decrease Payments
Another potential benefit of an adjustable-rate mortgage is that your future payments may actually go down after the first adjustment period. If market conditions have leveled out and interest rates have fallen by the time your fixed rate period has ended, then you’ll end up with a lower rate than you had before. And, your rate can conceivably keep going down each time your loan needs to be adjusted.
Cons of an Adjustable Rate Mortgage
Risk of Payment Increases
Of course, one of the main reasons borrowers choose to go with a fixed rate loan is that they have peace of mind that their rate will never change unless they choose to refinance to a lower fixed rate. With an ARM loan, you may have secured a lower initial interest rate, but after your first term is over your rate can continue to rise, leaving you with larger and larger monthly payments. Many borrowers simply can’t afford to take this risk and prefer a loan with a longer term but a rate that won't fluctuate. Even with a rate cap in place, a fluctuation of an entire percentage point can make a substantial difference in what you owe.
Financial Circumstances Change
ARM loans are very popular with borrowers who don’t think they’ll own their home for many years. Perhaps you plan to live in a certain area temporarily for work, or you’re a real estate speculator and plan to flip the property a few years down the line. Many homeowners who choose ARM loans plan to refinance in a few years.
For these people, ARMs can be the right choice; but what happens if your financial circumstances change? If you end up losing a well-paying job or staying in a home long past your initial rate period you may be stuck with a monthly mortgage payment that you can no longer afford. Or, if you made an incorrect prediction that the housing market in your area was going to improve, you may be left with a house that’s worth less than what you bought it for and a monthly loan payment you can’t make.
Possible Prepayment Penalties
Lastly, depending on the terms you agreed to with your lender, you may be on the hook for a prepayment penalty under certain circumstances. Note that not all lenders require this, but in some cases, if you sell your home before a pre-specified period, your lender can actually charge you thousands of dollars for violating your contract. The rationale here is that the lender has extended you this loan amount at a lower rate, and expects to earn a certain amount of interest from the loan. Therefore, if you pull out of the deal early, the bank or lender will now be losing out on the revenue that made the loan worthwhile.
Always ask your lender whether this penalty is included in the terms of your loan before agreeing to anything. If you’re worried about this risk, you can always get a quote from another lender who won’t impose a prepayment penalty.
Should You Choose an Adjustable Rate Mortgage?
Buying a home is a big decision, and one that should only be done after significant planning and research. Before you can truly begin house hunting, you’ll need to know how you’re going to pay for it.
One of the first decisions you’ll have to make is what loan type works best for your financial goals and your budget. An adjustable-rate mortgage may seem too risky at first glance, but once you flesh out the terms and calculate how your payments will evolve over the life of the loan, you may find that this is the best choice. For others, a reliable 15-year or 30-year fixed rate mortgage will be preferable, especially if you can lock it in at a low rate and you plan to stay in your home for a long time.
Most mortgage lenders will be happy to answer your questions about the types of home loans available, and they can help you map out what the payments would look like five or 10 years down the line. If you have more questions about how to get a home mortgage, meet with a few home loan officers and ask family and friends for recommendations. As with any loan, you should always shop around and get quotes from different lenders to compare rates and fee structures.