When you’re working with a lender to buy a home, you’ll likely be offered a wide range of loan types to choose from. One of the loans your lender may offer is an adjustable-rate mortgage (ARM), which often comes with a lower interest rate than a fixed-rate mortgage.
While the rate on the ARM loan may be enticing, you need to be aware that some aspects of an ARM loan differ greatly from other kinds of mortgage — the mortgage rate in particular. Unlike traditional conventional loans, ARM loans have two types of interest attached to them: fixed and adjustable, which makes them trickier than other types of loans.
While ARM loans can be a great fit for the right buyer, they certainly aren’t right for everyone. It’s important to understand the differences before deciding if an ARM mortgage is right for you.
What is an ARM loan?
An ARM loan is a mortgage loan that starts with a fixed interest rate. Once the period of fixed interest is over, the interest rate on ARM loans changes or adjusts periodically. In most cases, you’ll have a set interest rate for 3 to 7 years. Once that’s over, the rate adjusts yearly. Depending on your loan, the interest rate can change annually or even monthly after the initial fixed period.
With a 5/1 ARM, the initial rate is set for five years, and the rate will change every year after that. You typically find ARM loans with terms of 3/1, 5/1, 7/1 or 10/1. The first number reflects the fixed-rate period of the loan and the second number reflects how often the rate can change (which is once per year).
The introductory rate on an ARM mortgage is often lower than what the lender is charging for a fixed-rate loan, but that will likely change in the future when the adjustable term comes into play. If interest rates rise after you take out your adjustable-rate mortgage, your monthly mortgage payment will go up as well after the rate adjusts.
With an ARM loan, your interest rate is based on two factors:
- An index: The index it’s based on is a reflection of how interest rates are moving. For example, your lender may use the U.S. prime rate or the Constant Maturity Treasury Index.
- The margin: The margin is the extra percentage the lender adds to the index to determine your interest rate. If the prime rate is 3% and the loan has a 2% margin, your interest rate would be 5%.
An adjustable-rate mortgage often has limits on how much the interest rate can change per year. These limits are called caps. On a 5/1 loan, if the initial rate is 4% and you have a 2% cap on yearly changes, the rate could go to as high as 6% with the first adjustment.
There is also a cap on how much the interest rates can change over the life of the loan. Depending on how long the initial adjustment period is, the cap is 5 or 6 points on an FHA loan over the life of the loan.
ARM vs. fixed-rate mortgages
A fixed-rate loan is, in many ways, the opposite of an ARM. With a fixed-rate mortgage, you pay the same interest rate for the life of the loan. Your payment for principal and interest (P&I) won’t change over the years, and that’s the bulk of your mortgage payment. Note, though, that your mortgage payment still may change if your lender collects escrow money for homeowner’s insurance and real estate taxes, because those costs can rise or fall.
With an ARM loan, the interest rate can change substantially over the life of the loan. If it starts at 3% and has a 6% cap on changes over the life of the loan, you could be paying 9% interest sometime in the future. The increases aren’t a guarantee, though. Your rate can also drop with an ARM loan, but it will depend on the factors that dictate rate changes.
Fixed-rate loans are the better choice if you want the amount of your mortgage payment to be stable. If you’re on a tight budget or just prefer consistency, a fixed-rate loan will be a much better fit.
ARM loans are less predictable, and many people choose an adjustable-rate mortgage when they plan to stay in the house for a short time — or if they expect rates to drop in the future. That can be hard to predict, though. What you can predict are moves. If you have a 5/1 loan and sell before the five years are up, you won’t have to pay a higher interest rate due to adjustments with your rate.
Benefits of an ARM loan
The main benefit of an ARM mortgage is the low initial mortgage rate. That lower rate may allow you to buy a more expensive house than you could otherwise afford or help you save money because of the lower interest rate. If you plan to sell the home before the interest rate adjusts, you can benefit from the lower cost the entire time you live in the house.
If you know you’re going to have a higher income in the future, choosing an ARM loan allows you to benefit from the lower initial rate while still affording the potential for increased mortgage payments in the future.
For instance, an ARM loan might make sense if you:
- Have a partner who quit working to pursue an advanced degree and plans to return to the job market after graduation.
- Work for a company where you are guaranteed an annual raise.
And remember, an adjustable-rate loan may adjust down if interest rates decline. In that situation, you could take advantage of lower interest rates without the trouble and expense of refinancing your mortgage. But again, that’s a hard one to predict, so you shouldn’t rely on the potential for a lower interest rate in the future.
The drawbacks of an ARM mortgage loan
The biggest drawback to an ARM mortgage is unpredictability. You cannot know for sure how much interest rates will change or how quickly they will go up.
Life is also unpredictable. While you may intend to move before your ARM loan adjusts, your plans could change or the economy could be in a recession, making it difficult to sell your home.
An adjustable-rate mortgage is also a complicated loan, with many more details to consider when compared to a fixed-rate loan.
If you’re considering an ARM loan, the Consumer Financial Protection Bureau suggests finding out:
- When the interest rate adjusts and how often
- The index and margin that determine the rate
- The caps on how much the rate can increase
- Whether the rate can go down as well as up
- Whether there’s a prepayment penalty if you pay the loan off early or sell the house
ARM mortgage typical rates
While ARM mortgages often have a lower initial rate than a standard mortgage, that advantage is minimal with the record low interest rates in 2020. Both a 30-year fixed-rate loan and a 5/1 ARM have similar interest rates to conventional loans, which are close to 3%.
The interest rates on a 5/1 and 7/1 ARM are also higher right now than the interest rate being on a 15-year fixed-rate. The 15-year fixed-rate is at least a quarter of a percentage point lower than the adjustable rates, making it tough to justify the “what-ifs” that come with ARM loans.
ARM Loan FAQs
It depends on your loan. Some loans have a “floor” that cap how low the rate can fall. This means that if your rate starts out at the floor, your rate can’t fall below it — even if the index governing your mortgage goes lower.
A teaser rate is an introductory rate that is less than the sum of the index and margin. It results in a lower payment while the teaser rate is in effect, but you will likely pay more once the teaser rate expires. That’s a possibility even if interest rates in general go down. That’s because your future rate is determined by adding the index and margin and using the sum.
Adjustable-rate mortgages tend to become more popular when interest rates go up. For example, in December 2018, when average mortgage rates were over 5%, nearly one-tenth of the mortgages closed were ARM loans.
Too long, didn’t read?
ARM loans are more complicated than a standard fixed-rate loan. These types of loans also make it hard to predict what your monthly payment will be in the future. That doesn’t mean they’re not useful, though. ARM loans can be a good fit for the right person in the right capacity.
With mortgage interest rates near record lows right now, though, the drawbacks of an ARM could outweigh the benefits. You’ll have to compare the loan options you have to figure out whether that’s true for your needs.
