There are several mortgage options to choose from when shopping for a new home. For example, while many mortgages come with fixed rates, you might consider an adjustable-rate mortgage (ARM) to take advantage of a low introductory annual percentage rate (APR). However, rates on ARMs can also fluctuate with market conditions, meaning your rate and payments could rise in the future.
If you’re wondering how an ARM works and whether getting one is a good choice for your situation, here’s what you should know.
What’s an adjustable-rate mortgage?
An ARM (also known as a variable-rate mortgage) is a home loan that comes with a variable interest rate, meaning the rate can rise or fall according to market conditions. ARMs can be conventional loans or backed by a government agency. For example, both the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA) provide adjustable-rate options for their loans.
ARMs typically start out with an initial fixed interest rate for a set period of time — usually three, five, seven or 10 years. This introductory rate is often lower than a comparable fixed-rate mortgage, which can save you money on interest at the beginning of the loan.
Once this initial fixed-rate period ends, the rate will switch to variable and can readjust during the remainder of the loan term, depending on the market. This means your rate could either decrease or increase. Your loan payment will also change if your rate fluctuates, which can make it hard to factor your mortgage into your budget.
How it works
An ARM usually starts with a lower, fixed interest rate for the first few years of the loan before switching to an adjustable rate. Rate adjustments can happen annually or every six months, depending on your loan terms.
The interest rate on an ARM is based on an index interest rate that corresponds with current market conditions. Mortgage lenders will use the index rate as a basis for your ARM interest rate and then add a few percentage points — usually referred to as the margin — to arrive at the amount of interest you’re charged.
Because this index rate can go either up or down with the market at any given time, you could end up paying more or less on your monthly mortgage payments throughout your repayment term.
Types of adjustable-rate mortgage loans
There are a few types of ARMs. Here are the most common kinds:
- 3/1, 5/1, 7/1 or 10/1: With this type of ARM, your rate will adjust annually following the initial fixed-rate period. The first number refers to how long the fixed interest rate lasts. The second number is how often the interest rate adjusts after the fixed rate ends. For instance, a 3/1 ARM means the interest is fixed for the first three years of the loan. Then it adjusts every year after that.
- 3/6, 5/6, 7/6, 10/6: Rather than adjusting annually, these types of loans adjust every six months. The first number refers to the length of the fixed-rate period, while the six refers to the rate adjusting on a semiannual basis after that.
- Interest-only: This type of ARM allows you to make only interest payments for an initial period of time — usually between three to 10 years — before you begin to also pay off the principal balance of your mortgage. This means your payments will start low and increase over time.
Pros and cons of an ARM
Pros
- Lower introductory rate: You’ll typically get a lower introductory interest rate compared to fixed-interest mortgages. This rate is also fixed, meaning your payment won’t change during this time. Having a lower initial fixed rate means your payments will be lower, too.
- Rate and payments might drop: Depending on market conditions, your rate and therefore your payments could decrease during adjustment periods.
- More flexibility: An ARM can be a good option if you plan to sell your home or refinance before the fixed-rate period ends.
Cons
- Less stability: Unlike with a fixed-rate mortgage, an ARM’s rate and payments can fluctuate over time and make it hard to fit your mortgage within your budget. Plus, plans to sell or refinance before the fixed-rate period ends on your ARM could always fall through.
- Rate and payments could increase: Your rate and payments might increase, depending on market conditions. If you’re on a tight budget, it might be hard to afford these changes.
- More complex: Having to keep up with changing market conditions and rates can make ARMs more complicated compared to fixed-rate loans.
Adjustable-rate mortgage terms
There are some common terms that are important to understand if you’re considering an ARM. Here are a few to remember:
- APR: A loan’s APR is the cost you’ll pay in return for borrowing money from a lender, expressed as a percentage. It includes both the interest as well as any fees associated with the loan (such as origination fees or mortgage insurance).
- Adjustable (or variable) interest rate: This type of interest rate can fluctuate during the loan term according to market conditions. The rate on an ARM will adjust based on the index used by your lender as well as the margin.
- Index: This is a benchmark interest rate that’s set according to market conditions. Lenders choose which index to use when setting ARM rates — common ones include the federal funds rate and the Secured Overnight Financing Rate (SOFR).
- Margin: This refers to the number of percentage points that a lender adds to the index when setting the rate on an ARM.
- Interest rate cap: Many mortgage lenders put a cap on how much a rate can increase at different points during your repayment term. There are a few types of rate caps that can affect an ARM, including the initial cap, periodic cap and lifetime cap.
- Initial rate cap: This is the maximum increase allowed for your rate after the fixed-rate period ends — usually 2% to 5%, depending on your loan terms.
- Periodic rate cap (or subsequent adjustment cap): This is the limit to how much the rate can increase during the adjustable period following the initial cap. It’s usually around 2%.
- Lifetime rate cap: This is the limit of how much your rate can increase over the full life of your loan.
- Repayment term: This is the set period of time that you have to repay your loan. ARMs usually come with 30-year terms.
ARM vs. fixed-rate mortgage: What’s the difference?
The main difference between an ARM and a fixed-rate mortgage is the type of interest rate. An ARM’s rate can change regularly according to market conditions, meaning your payments can go up or down when it comes time to adjust. In a high-interest rate environment, your payments could increase significantly — or they could drop if mortgage rates fall. Remember that lenders put caps on how often and how much your rate can change throughout your repayment term.
With a fixed-rate mortgage, your interest rate won’t change over the life of the loan. This provides more stability and presents less of a risk for your budget. However, you might end up paying more in interest with a fixed-rate loan compared to an ARM — namely if you don’t stay in the home for a long period of time.
Tip: First-time homebuyer programs typically offer fixed-rate loans. However, if you plan to move or refinance your home within the first few years, an ARM could still be a good fit — and might help reduce your overall costs.
When you should get an adjustable-rate mortgage
While ARMs aren’t the right option for every borrower, they can be ideal in certain situations. For example, you might want to get a mortgage with an adjustable rate if:
- You want lower monthly payments during the beginning of your loan.
- You’re happy with a shorter repayment period or you plan on paying off your mortgage early.
- You don’t expect to live in the home for the entirety of your repayment term.
- You can afford higher payments if your rate rises.
Frequently asked questions (FAQs)
Yes, you can refinance an ARM — either into another ARM or into a fixed-rate mortgage. Refinancing can be a good idea if you can qualify for a lower rate or better terms or if you want to speed up your repayment to pay off your loan sooner.
Yes, you can pay off an ARM early if you choose. However, some lenders charge prepayment penalties if you pay off your loan much sooner than the loan terms outline. Be check your loan agreement or contact your lender to see if there’s a prepayment penalty and how much it is to see if repaying the loan early is worth it.
An ARM can often be cheaper in interest at the beginning of a loan during the fixed-rate period. This means you could end with lower overall costs if you plan to sell the home or refinance before this period ends.
If you stay in the home after the introductory period ends, your rate could change substantially, depending on market conditions. When the rate adjusts, there’s a chance that your interest rate will increase. If this happens, not only will your monthly mortgage payment increase significantly, but you could also end up paying more than individuals who have fixed-rate mortgages.
