When you’re shopping for a mortgage loan, there are many factors to consider. This includes deciding whether to choose a fixed-rate or an adjustable-rate mortgage (ARM). While fixed-rate loans have the same interest rate and payment throughout the entire life of the loan, an ARM has a rate that adjusts periodically, and its payments adjust along with it.
An ARM may be advantageous in a high-rate environment or if you’re planning to pay off your loan by selling your home or refinancing before your introductory period has ended. Learn how an ARM works, common types of ARMs, and a few other financing options you may consider.
What Is an Adjustable Rate Mortgage?
An adjustable-rate mortgage is a home loan that has a variable interest rate. When you first take out an ARM, you have a low fixed rate for a set period. Once this introductory period ends, a new rate is applied to the outstanding balance, and the payment adjusts accordingly. This rate changes periodically throughout the loan period, typically at annual or monthly intervals.
Interest rates fluctuate based on a variety of factors, including inflation, supply and demand for borrowed money, government borrowing, and the Central Bank’s monetary policy. ARMs are typically set according to an index, such as the Secured Overnight Financing Rate (SOFR), plus an additional spread called the ARM margin. If the SOFR has gone up when it’s time to reset your ARM, both your rate and your payment go up. Conversely, if the SOFR is lower, your rate and payment would go down.
In certain circumstances, it may make sense to take out an adjustable-rate mortgage. For instance:
- You plan on selling or refinancing your home before the initial rate period ends.
- Interest rates are currently high, and you expect them to be lower in the future.
- You can afford to make higher payments if your rate adjusts upward.
How Does an Adjustable Rate Mortgage Work?
Typically, ARMs have low introductory rates that are fixed for a predetermined number of years. During this time, your payments are fixed too. At the end of the fixed period, your rate resets at predetermined intervals according to a preselected benchmark index. The rate continues to reset periodically until you refinance your mortgage, pay it off, or sell your home.
ARMs typically have 30-year terms, and the fixed interest rate is locked for the first 3, 5, 7, or 10 years. You can tell the terms of an ARM by looking at its name. For example, a 5/1 ARM has a fixed introductory rate for 5 years and then resets every year. In addition to 5/1, other common ARMs are 3/1, 7/1, and 10/1.
ARMs also have caps that limit how much your interest rate and payment can change from each period to the next, which helps to protect you from drastic increases. This includes:
- Periodic rate cap: This limits how much the interest rate can increase from each reset period to the next.
- Lifetime rate cap: This limits how much the interest rate can increase in total over the lifetime of the loan.
- Payment cap: This limits the monthly payment increase over the loan’s lifetime in dollars, rather than percentage points.
How Rates Are Calculated
To calculate your interest rate, the lender starts with the current index rate and adds a set amount of percentage points, also called the margin. While the index rate changes periodically, the margin is agreed upon when you take out the loan and remains the same throughout the loan period.
For example, if the index is currently at 1.5% and the margin is 3.5%, this combines for a 5% interest rate. When the next reset period comes, if the index is 2%, the lender adds the 3.5% margin, and your new interest rate is 5.5%.
Advantages of ARMs
There are several reasons you might consider taking out an adjustable-rate mortgage. Here are a few potential advantages:
- Lower initial interest rates, which translate into lower payments
- The flexibility to allocate funds elsewhere during the introductory period
- Potential for a lower interest rate and payments in the future
- Cap limits that prevent interest rates and payments from rising above an agreed-upon maximum
Disadvantages of ARMs
While ARMS do have some benefits, they’re not right for everyone. Before choosing an ARM, consider these potential drawbacks:
- Your interest rates and payments could increase
- You may be unable to sell or refinance before your introductory period ends
- Complicated structures, rules, and fees could create risks
- Some ARMs may have a prepayment penalty
Common Types of ARMs
There are several different types of ARMs available to borrowers, each with its own unique features. Here’s a look at three of the most common options.
Hybrid Adjustable Rate Mortgages
A hybrid ARM is another name for a traditional adjustable-rate mortgage. In the past, traditional ARMs were typically based on the London Interbank Offered Rate (LIBOR) and were adjusted once per year. Today, many ARMs are based on the Secured Overnight Financing Rate (SOFR) and adjust every 6 months after the initial period. In this case, a hybrid loan with an initial fixed interest rate for 5 years may be called a 5/6 or 5/6m ARM.
ARMs with shorter introductory periods tend to have lower initial interest rates than those with longer introductory periods. For example, a 3-year ARM typically has a lower introductory rate than a 10-year ARM.
Interest-Only Adjustment Rate Mortgages
With an interest-only (IO) ARM, you only pay interest on your mortgage during the introductory period, which is typically between 3 and 10 years but could be as short as a few months. This keeps your monthly payments low during the interest-only period. An IO ARM can be advantageous if you do not plan on keeping the home for long, you have a variable income, or you need some time to stabilize your finances before starting to make larger payments.
However, there are some potentially significant risks to consider. Since you are not making principal payments, at the end of the introductory period, you still owe the same amount as you did when you initially took out the loan. Unless your home appreciates, you will not be building any equity during that time.
It’s also important to carefully consider how you plan to prepare to make higher payments in the future. When your introductory period ends, your required minimum monthly payment switches from interest only to principal and interest payments. In some cases, this could cause your payment to double or even triple. There’s also the risk that your interest rate could go up when it resets, further increasing your monthly payments. Without a solid plan, you could find yourself unable to make your payments, which could potentially lead to foreclosure.
Payment-Option Adjustment Rate Mortgages
A payment-option ARM is a complex loan that allows the borrower to choose their own payment schedule and loan structure. For example, you may choose a 15-, 30-, or 40-year term and select from payment options including interest-only, fully amortized monthly payments, or any other payment amount equal to or greater than a preset minimum payment amount.
Although these loans were popular in the past, they became rare after millions of U.S. homeowners defaulted on their mortgages during the 2008 Great Recession. A major problem with these types of mortgage loans is that they allow for negative amortization, meaning that your loan balance could actually increase if your payments are not enough to cover the interest. In some cases, if the loan balance gets too high, the lender could recast the loan, requiring you to make much higher payments that could become unaffordable.
Other Options to Consider
If you’re not sure whether an ARM is right for you, there are a variety of other options to consider. This includes fixed-rate mortgages, such as Federal Housing Administration (FHA) and Department of Veterans Affairs (VA) loans, and jumbo loans. Here’s a look at how each of these compares to an ARM.
ARMs vs. Fixed-Rate Mortgages
A fixed-rate mortgage has a single fixed interest rate that remains the same throughout the entire loan period. Your interest and principal payment also remain the same. However, if you have escrow, your actual payment may fluctuate depending on the cost of your homeowner’s insurance and property taxes. A fixed-rate mortgage may make sense if interest rates are low, since it may be a good idea to lock in your rate rather than take a chance on future fluctuations.
While the interest rate on a fixed-rate mortgage is typically higher than the introductory rate on an ARM, many borrowers prefer a fix-rate mortgage because it’s predictable. Knowing that your monthly mortgage payment will not change can make it easier to manage your cash flow. If you have a tight monthly budget, even a small ARM adjustment could create a problem. On the other hand, if you’re buying your “forever” home, fixed payments can give you greater stability and remove the anxiety that can come with periodic rate adjustments.
ARMs vs. FHA and VA Loans
If you’re looking for a loan with a low interest rate and low down payments, an FHA or VA loan may be an option to consider. An FHA loan is a government-backed loan that’s secured by the Federal Housing Administration. These loans typically have lower credit score and down payment requirements than conventional loans. This makes them particularly attractive to first-time homebuyers, though eligibility is not limited to first-time buyers. FHA loans may also have lower interest rates than traditional mortgages. However, if you put less than 20% down, you have to pay FHA mortgage insurance, which increases your payments.
VA loans are issued by private lenders and backed by the U.S. Department of Veterans Affairs. These loans are exclusively for active-duty military members, veterans, and eligible surviving spouses. They allow you to purchase a home with no down payment and offer lenient credit requirements. VA loans also do not require mortgage insurance (though there is a funding fee) and typically have lower interest rates than traditional mortgages.
Both FHA and VA loans could be viable options for borrowers who are looking for competitive rates and don’t want to take on the risks of an ARM.
ARMs vs. Jumbo Loans
Fannie Mae and Freddie Mac are government-sponsored agencies that purchase home loans and package them for investors. The Federal Housing Finance Agency (FHFA) sets the maximum loan size Fannie Mae and Freddie Mac can acquire. In 2022, the conforming loan limit (CLL) for single-unit homes in most parts of the U.S. is $647,200. Borrowers who need more than this amount need to take out a jumbo loan.
Jumbo loans are mortgage loans for amounts that exceed the CLL. These loans can be used to purchase your primary residence, vacation home, or investment properties. Since they represent a greater risk for the lender, jumbo loans typically have stricter underwriting rules, require larger down payments, and have higher interest rates than standard mortgages. If you’re in the market for an expensive home and need a loan that exceeds the CLL for your area, you may consider a standard jumbo loan or a jumbo ARM, which works the same way as a traditional ARM, but with higher lending limits.