Adjustable Rate Mortgages – Everything You Need to Know
What you'll learn: Thinking about an ARM loan? Find out everything you need to know to decide if a variable rate mortgage is right for you.
EXPECTED READ TIME: 5 MINUTES
August 25, 2022
An adjustable-rate mortgage (ARM), also called a variable-rate mortgage, offers homebuyers many potential benefits. ARMs often become more popular when interest rates are rising because their low initial rates can mean serious savings. Read on to learn everything you need to know about this mortgage option and see if it might be right for you.
What is an ARM?
As the name implies, an adjustable-rate mortgage has an interest rate that can change over time. Whereas a fixed-rate mortgage locks in a rate for the full term, an ARM’s rate will fluctuate with market conditions. That means your loan payment will go up or down throughout the life of your loan.
ARM loans are made up of two distinct periods:
- Fixed-rate period - ARMs begin with a fixed-rate period for a set length of time. The interest rate will not change during this period. Your loan will have a set fixed-rate period length, which usually ranges from three to 10 years, but can be longer.
- Adjustable-rate period - After the fixed-rate period ends, ARMs transition to an adjustable-rate period. This is when your mortgage payment will go up or down based on market conditions. Adjustments typically occur once every six months or year and continue for the remainder of the loan.
How ARMs work
Your interest rate during the adjustable period is determined by two factors: an index and a margin. Together, they determine your mortgage payment.
- Index rate - A benchmark that goes up and down based on the market; often tied to the Secured Overnight Financing Rate (SOFR)
- Margin rate - Set by your lender and fixed for the life of the loan
For example: If the SOFR index value is 2 percent, and your margin is 2.75 percent, your interest rate will be 4.75 percent. If the index has decreased during your next adjustment period, your mortgage payment will decrease with it. If the index increases, your mortgage payments will also increase.
Adjustable rate caps protect you from dramatic rate increases
Most ARMs come with caps. Think of them as guardrails: They help to limit your risk of sudden, large payment increases due to rising rates. There are three main caps that may be available:
- Initial Adjustment Cap – The maximum a rate can increase when transitioning from the fixed-rate period to the adjustable-rate period
- Subsequent Adjustment Cap – The maximum a rate can increase after each adjustment period
- Lifetime Adjustment Cap – The maximum a rate can increase above the initial fixed rate for the life of the loan
Types of ARMs
Lenders offer many different types of ARMs – sometimes even for VA and FHA loans. Here are some common examples and what they mean.
- 3/1 ARM – Fixed rate for three years; then the rate adjusts annually
- 5/1 ARM – Fixed rate for five years; then the rate adjusts annually
- 5/6m ARM – Fixed rate for five years; then the rate adjusts every six months
- 7/1 ARM – Fixed rate for seven years; then the rate adjusts annually
- 10/6m ARM – Fixed rate for ten years; then the rate adjusts every six months
There are additional differences between the loans too. Look at the term length, margin, and caps when comparing your options between lenders.
Benefits of ARMs
ARMs are known for offering lower introductory rates compared to conventional fixed-rate mortgages. A lower interest rate can mean a lower mortgage payment and more money going toward the principal each month – building equity and paying off your home loan faster. It could also mean more buying power to purchase the home of your dreams.
The other major benefit is that your interest rate will decrease if the index falls during your adjustable rate period. That leads to even greater savings.
Curious about other benefits? See the top five reasons to get an ARM.
Risks of ARMs
It’s important to understand that variable-rate mortgages come with risk. There is no security of a consistent rate and mortgage payment. If rates increase, your payment will increase as well. Fluctuating payments can cost you more and make it harder to budget.
Variable-rate mortgages are often associated with the 2008 financial crisis. During that time, many borrowers were approved for loans they couldn’t afford once the introductory period ended and rates increased. Lenders now have stricter oversight and work to educate consumers about the risks involved.
Example: ARM vs. fixed-rate loan
Consider the following example showing potential interest rates over the course of a 30-year ARM and conventional fixed-rate mortgage. While the fixed rate stays steady for the entire term, the ARM fluctuates up and down after its initial five-year fixed period. Depending on which way the rate goes, it could mean significant savings (or additional costs) for the borrower throughout the life of the loan.
|5/1 ARM||30-Year Fixed|
|Rate After 5 Years||4.00%||4.25%|
|Rate After 29 Years||3.00%||4.25%|
Compare the pros and cons of ARMs and fixed conventional loans.
So, is an ARM a good idea?
There are no rules for when a variable-rate mortgage is the best option. However, there are tried-and-true guidelines to help decide if an ARM is right for you.
You may consider an ARM if:
- You’re comfortable with some level of risk
- Rates are rising and you want the lowest upfront rate as possible
- You plan to sell the property before the fixed-rate period ends
- You plan to refinance before the adjustment period begins
Is an ARM right for you?
With interest rates on the rise, many homebuyers are considering the potential savings available with adjustable-rate mortgages. ARMs are not as straight-forward as conventional mortgages. Enlist the help of an experienced loan officer to help you weigh your options.