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Purchase, Homebuying 101, First time homebuyer, Finding a home
When Rates Rise – Is an ARM Mortgage a Good Idea?
What You'll Learn: What to Look at When Considering an Adjustable-Rate Home Loan.
EXPECTED READ TIME: 9 MINUTES
April 1, 2022
What Are ARMs?
An adjustable-rate mortgage (ARM) is a type of loan that provides borrowers with a lower rate for an initial fixed period. The terms are usually 3, 5, 7, or 10 years. After this initial period, the loan rates will adjust each year depending on market factors.
Most ARMs will use an index rate called the Secured Overnight Financing Rate (SOFR) to determine their adjustments. One good thing is that most ARMs will have a predetermined rate increase cap which is the maximum amount that a rate can increase in a single year. The cap is your worst-case scenario increase once you are past the fixed period.
You will see ARMs named with numbers that look like this: 7/6m
- The first number, 7, is the fixed period number of years, and the second part, 6m, is the adjustment time, so there are adjustments every six months after the fixed period completes.
- During an ARMs adjustment period, the rate will adjust using the following formula:
30 day average of SOFR (Index) + (Margin)
Over the last ten years, the margin has stayed around 2.74% to 2.76%. But the SOFR index's value varies. The New York Federal Reserve maintains the SOFR index, and you can access the current numbers here.
Adjustable-Rate Mortgage Pros & Cons
The main advantage of an adjustable-rate mortgage is that during the fixed period, the rate for the mortgage will be lower (sometimes significantly) compared to a fixed-rate mortgage.
Let's take a look at some example current rates:
Loan type |
(Initial) Rate |
30-year Fixed |
4.25% |
5/1 |
3.125% |
7/1 |
3.25% |
10/1 |
3.375% |
ARMs rates are for the fixed period, then adjust
You can see the trends of ARM rates for the last year here.
These differences may not look significant, but they can result in savings over time. However, after the fixed period ends, you would have a rate based on the SOFR and the margin, resulting in your payment going up (or down). Many homeowners plan on refinancing before their loan adjusts.
If you are in a period of rising rates (as we are now in 2022), an ARM can lock in a lower rate, and you can watch the rate climb without worry until the fixed-rate period expires.
No one knows what rates will do. But with the help of Freddie Mac, we can take a look back at history to see what they've done in the past. From 1975 to 2021 (47 years), 19 years have seen rates above 8%, and all were before 2000.
The main con of an ARM is if rates climb too much, you would eventually overcome the savings you obtained during the fixed-rate period.
Adjustable-Rate Mortgage Risks
The most significant risk is that the rates will climb significantly after the fixed period. But remember, an ARM has "caps," limiting the amount that the rate can increase. Caps are your friend protecting you from sharp rate moves during the adjustment period.
There are Three Types of Caps
- Initial Adjustment Cap – 2% to 5% is generally the most your rate can increase when you transition from the fixed-rate period to the adjustable-rate period.
- Subsequent Adjustment Cap –2% is generally the most a rate can increase after each of the adjustment periods.
- Lifetime Adjustment Cap – 5% generally the most that a rate can increase above your initial fixed rate for the life of the loan.
