Adjustable-Rate Mortgages: Pros and Cons

If you are looking for the right mortgage for your home loan needs, you may have heard of adjustable-rate mortgages (ARMs). Also referred to as variable-rate loans, an adjustable-rate mortgage can offer homebuyers a number of potential benefits in certain situations. However, due to their varying interest rate structure, ARMs can be difficult for borrowers to comprehend.

In this article, we will detail how ARMs work, along with their potential advantages and disadvantages so you can determine if one is right for you.

What is an adjustable-rate mortgage?

Just like the name implies, an ARM is a home loan with an interest rate that can change over time. Unlike a fixed-rate mortgage that has a set interest rate that does not change for the life of the loan, an adjustable-rate mortgage’s rate will fluctuate every six months or annually depending on your terms and market conditions.

There are two distinct periods that make up the structure of an adjustable-rate mortgage:

• The fixed-rate period is a set length of time, typically between three and ten years, during which your interest rate will not change.

• The adjustable-rate period begins after the fixed-rate period ends. This is when your mortgage payments and interest rate may fluctuate depending on market conditions. The adjustments occur once every six months or year, depending on your loan terms, and continue for the rest of the loan’s life.

How do ARMs work?

There will be two factors that determine your interest rate during the ARM’s adjustment period: an index and a margin. The index rate is a benchmark that will go up or down depending on the market (often this is tied to the Secured Overnight Financing Rate). The margin rate is set by your lender and will be fixed for the life of the loan.

Let us use an example to see these adjustments in action: If the Secured Overnight Finance Rate is 2%, and you have a margin of 2.75%, then your interest rate will be 4.75%. If the index decreases before the loan’s next set adjustment, then your mortgage payments will decrease as well. However, should there be an increase, then that means your mortgage payments will increase.

Adjustable-rate mortgage pros

That being said, there are a number of reasons why ARMs increase in popularity when interest rates are on the rise. Some advantages of opting for an adjustable-rate mortgage include:

Low initial payments during the fixed-rate phase

In comparison to their fixed-rate mortgage counterparts, an ARM will often come with a lower initial interest rate. This means you will get a lower monthly mortgage payment throughout the fixed-rate period.

Homebuyers who plan to sell prior to the end of the fixed-rate period could save more on interest with an ARM.

Flexibility to refinance or sell sooner

Another great aspect that makes ARMs attractive to homebuyers is the flexibility they offer. An adjustable-rate mortgage may be right for you if you are more likely to sell your home sooner rather than later or you plan on refinancing as your loan reaches the end of its fixed-rate period.

Rate and payment caps

Adjustable-rate loans will also have caps on how high your rate can increase. So, even if your monthly mortgage payments do rise in the future, there is a limit. However, it is incredibly important to pay attention to your loan’s terms and mortgage disclosures to ensure you’re comfortable with the potential increases.

Adjustable-rate mortgage cons

Though ARMs can offer some money-saving opportunities in certain situations, there are a few disadvantages that you should be aware of before signing on the dotted line.

Potential for payments to increase

Any increase in your mortgage rate during the loan’s adjustment period will mean your mortgage payments get a bump as well. This can cause issues if you are not prepared for a sudden increase in your payments, and may lead to the need to cut costs in other aspects of your life.

Limited availability

It is also important to note that not all lenders offer adjustable-rate mortgages. Those that do have them available may not offer the exact terms you need in order to enjoy the benefits of an ARM.

Harder to budget 

Budgeting with a fixed-rate mortgage is pretty straightforward since your rate will not change and you do not have to worry about any changes to your monthly payments. Unfortunately, that is not the case with ARMs.

Once the fixed-rate period comes to an end, changes in your rate and payments will occur periodically. These adjustments aren’t always predictable, making it frustrating for homeowners to budget for.

Is an ARM right for you?

Adjustable-rate mortgages can be a great option, especially if you plan on selling your home in the near future or decide to refinance prior to the end of the fixed-rate period. However, if you have an unpredictable income or struggle with sudden changes to monthly payments that effect your budget, an ARM may not be a good fit.

At the end of the day, it all comes down to your unique situation and home loan needs. That is why it is important to discuss with a trusted mortgage lender who can walk you through all of your loan options and help find the best one for you.