An adjustable rate mortgage, or ARM, is a mortgage in which the interest rate can change over time. With an ARM, your mortgage payment either goes down or up, depending on the current index rate your mortgage is tied to.
While having your rate be unknown over time can cause some anxiety, there are great reasons why you may want to consider an ARM when you purchase your home. In this article, we’ll cover five benefits of an adjustable rate mortgage and when one may make sense for you.
1. Lower initial rate and monthly payments
One of the most compelling adjustable rate mortgage advantages is that the initial rate is almost always lower than a 30-year counterpart, leading to a lower monthly payment.
That’s because ARMs start with an introductory fixed-rate period before they become variable. For example, a 15-year ARM has a fixed rate for the first 15 years of its term. The interest rate and initial payments are generally lower than those of a comparable 30-year fixed rate loan. You may choose to use that money to save for retirement, pay down other debt, or even pay down the mortgage faster.
2. Possible ongoing savings
Once you reach your adjustment rate period, your interest rate will fluctuate on a set schedule – often annually – based on the market. If interest rates drop, your payments will automatically drop. On a fixed rate mortgage, you would have to refinance to take advantage of a lower interest rate, which can be costly and time-consuming.
Just remember that the opposite can also be true. If rates rise, your monthly payments will also go up.
3. Rate caps limit risk
Adjustable rate loans will have caps on the rate at which they can increase, which means that even if your costs do go up, there is a limit. Be sure to pay attention to the terms of your mortgage disclosures to make sure these maximum increases are numbers you are comfortable with. Read and understand all of your loan documentation and ask questions if you have any.
4. Flexibility to refinance or sell
Can you refinance an adjustable rate mortgage? Yes. And it’s a common strategy for ARM borrowers nearing the end of their fixed rate period – especially if rates are on the rise.
If you're likely to move in five to seven years and the home you're looking to buy won’t be your forever home, an ARM may make a lot of sense. If ARM rates are lower than a 30-year fixed, you can lock in the lower rate for five or seven years with a 5/1 or 7/1 loan. And before your rate changes, you might be moving to your next home.
5. More housing options
If you have a comfort level that your income may be increasing over time, taking a mortgage with a lower interest rate upfront might open the door to afford your dream home sooner. Be sure to run the numbers and ensure you don’t put yourself into a position of financial hardship in order to buy more house than you can realistically afford.
When should you consider an adjustable rate mortgage?
If you're deciding on whether to get a fixed-rate mortgage or an adjustable-rate mortgage, here are some questions to ask yourself:
- What are the rates for adjustable rate mortgages? Compare rates for 3/1, 5/1, 7/1, and 10/1.
- What are the current 30-year fixed rates for the loan size you need? You might also take a look at 15- and 20-year rates.
- Do you need a conforming loan amount or a jumbo loan? Interest rates vary depending on the loan amount, so make sure you're looking at the correct rate. Jumbo ARMs can be lower than 30-year fixed.
- What are the current interest rate trends? Are rates on the rise, or are they falling? If they're high, ARM rates will probably look appealing. If rates are at historic lows as they were in 2020, it may make more sense to lock a fixed-rate mortgage to secure these low rates for the life of your loan.
- How long do you plan on staying in the home? As outlined above, if you plan to move in a couple of years, an ARM might be the right choice.
- How frequently do the ARM rates adjust? Where do you see yourself at the end of the introductory period of 3 to 10 years? For example, if you're currently in the military and know you'll be relocating in a few years, consider that.
- Can you afford the mortgage if it goes up? If mortgage rates increase, can you afford to pay the new rates outlined in the mortgage caps?
Everyone's financial situation is different. With ARMs, it is your financial situation combined with the state of the economy and other factors like how long you plan on being in your home. In the end, it's always great to do your homework, understand all of your loan options, and talk to a loan officer you trust.