When the housing market collapsed in 2008, adjustable-rate mortgages took some of the blame. They lost more appeal during the pandemic when fixed mortgage rates bottomed out at all-time lows.

With fixed rates now closer to historic norms, ARMs are making a comeback and home buyers who use ARMs strategically are saving a lot of money.

Before getting an ARM, make sure you understand how the loan will work. Be sure to consider all the adjustable rate mortgage pros and cons, with an exit plan in mind before you enter.

Check your home buying eligibility. Start here (Apr 25th, 2024)

How does an adjustable rate mortgage work?

At first, an adjustable rate mortgage loan works like a fixed-rate mortgage. The loan opens with a fixed rate and fixed monthly payments.

Unlike a fixed-rate loan, an ARM’s initial fixed rate period will expire, usually after three, five, or seven years. At that point, the loan’s fixed rate will be replaced by a new mortgage rate, one that’s based on market conditions at that time.

If market rates were lower when the rate adjusts, the loan’s rate and monthly payments would decrease. But if rates were higher at that time, mortgage payments would go up.

Then, the loan’s rate and payment would keep changing — adjusting once a year, in most cases — until you refinance or pay off the loan.

Adjustable rate mortgage mechanics

To understand how often, and by how much, your ARM’s rate and payment could change, you have to understand the loan’s mechanics. The following variables control how an ARM works:

• Its initial fixed rate period
• Its index
• Its margin
• Its rate caps

Let’s look at each one of these variables up close:

The initial fixed rate period

Most ARMs have fixed rates for a certain amount of time. For example, a 3-year ARM’s rate is fixed for 3 years before it starts adjusting.

You may have heard of a 3/1, 5/1 or 7/1 ARM. This simply means the loan’s rate is fixed for 3, 5 or 7 years, respectively. Then, after the initial rate expires, the rate adjusts once per year (hence the “1”).

During this initial period, the fixed interest rate will be lower than the rate you would’ve gotten on a 30-year fixed rate mortgage. This is how ARMs can save money.

The shorter the initial fixed rate period, the lower the initial rate. That’s why some people call this initial rate a “teaser rate.”

This is where home buyers should be careful. It’s tempting to see only the ARM’s potential savings without considering the consequences once the low fixed rate expires.

Make sure you read the fine print on advertisements and especially your loan documents.

The ARM’s index rate

The fine print should name the ARM’s index which plays a big role in how much the loan’s rate will change over time.

The index is the starting point for the loan’s future rate changes. Traditionally, ARM rates were tied to the London Interbank Offered Rate, or LIBOR. But newer ARMs use the Constant Maturity Treasury Rate (CMT), the Effective Federal Funds Rate (EFFR), or the Secured Overnight Financing Rate (SOFR).

Whatever the index, it’ll fluctuate up and down, and your adjusting ARM rate will follow suit. Before you agree to an ARM, check how high the index has gone in the past. It may be headed back in that direction.

The ARM’s margin rate

The index is not the whole story. Lenders add their margin rate to the index rate to come to your total interest rate. Typical margins range from 2% to 3%.

The lender creates the margin in order to make their profit. It’s the amount above and beyond the current lending rates of the day (the index) that the bank collects to make your loan profitable for them.

The bank determines how much it needs to make on your ARM loan and sets the margin accordingly.

The ARM’s rate caps

For the most part, the index rate plus the margin equals your interest rate. Additionally, rate caps limit how far and how fast your ARM’s rate can change. Caps are a new innovation enforced by the Consumer Financial Protection Bureau to prevent your ARM from spinning out of control.

There are three types of rate caps.

• Initial cap: Limits how much the introductory rate can rise at its first adjustment period
• Recurring cap: Limits how much a rate can increase at each subsequent rate change
• Lifetime cap: Limits how far the ARM rate can rise over the life of your loan

If you read your loan’s fine print, you might see caps listed like this: 2/2/5 or 3/1/4.

A loan with a 2/2/5 cap, for example, can increase its rate:

• Up to 2 percentage points when the initial fixed rate period expires
• Up to 2 percentage points at each subsequent rate change
• A maximum of 5 percentage points over the life of the loan

These caps remove some of the volatility people associate with ARMs. They can simplify the shopping process, too. If your introductory rate is 5.5% and your lifetime cap is 5%, you’ll know the highest interest rate possible on your loan is 10.5%.

Even if your index rate went up to 15% and your margin rate was 3%, your ARM would never surpass 10.5%.

Granted, no American in the 21st century wants to pay a rate that high, but at least you’d know the worst-case scenario going in. ARM borrowers in previous decades didn’t always have that knowledge.

Check your home buying eligibility. Start here (Apr 25th, 2024)

Is an ARM right for you?

An ARM isn’t right for everybody. Home buyers — especially first-time home buyers — who want to lock in a rate and forget about it should not get an ARM.

Borrowers who stress about their personal finances and can’t imagine facing a higher monthly payment should also avoid these loans.

ARMs are often good for people who:

Want to maximize their savings

When you’re buying a $400,000 home with a 10% down payment, the difference between a mortgage at 7% and a mortgage at 6% is about $237 a month, or $2,844 a year. Since ARMs offer lower interest rates, they can create this level of savings at first.

Plus, paying less interest means the loan’s principal balance decreases faster, creating more home equity.

Want to qualify for a bigger loan

Rather than saving cash each month, some buyers prefer to direct their ARM’s initial savings back into their loans, generating more borrowing power.

In short, this means they can afford a bigger or more expensive home, because of the ARM’s lower initial fixed rate.

Plan to refinance anyway

A refinance opens a new home loan and pays off the old one. By refinancing before your ARM’s rate changes, you never give the ARM’s rate a chance to potentially increase. Of course, if rates have fallen by the time the ARM adjusts, you could hang onto the ARM for another year.

Keep in mind refinancing costs money. You’ll have to pay closing costs again, and you’ll need to qualify for the refinance with your credit score and debt-to-income ratio, just like you did with the ARM.

Plan to sell the home soon

Some home buyers know they’ll sell the home before the ARM adjusts. In this case, there’s really no reason to pay more for a fixed rate loan.

But try to leave a little room for the unexpected. Nobody knows, for sure, how your local housing market will look in a few years. If you plan to sell in three years, consider a 5/1 ARM. That’ll add a couple of extra years in case things don’t go as planned.

Don’t mind a little uncertainty

Some home buyers don’t know their future plans for the home. They simply want the lowest interest rate they can find, and they notice that an ARM provides it.

Still, if this is you, be sure to consider the possible outcomes of this loan option. Use a mortgage calculator to see your mortgage payment if your ARM reached its lifetime rate cap. At least you’d have a sense of how expensive the loan could become after its interest rate adjusts.

Pros and cons of adjustable rate mortgages

Pros:

• Low interest rate during the initial period
• Lower monthly payments
• Qualifying for a more expensive home purchase
• Modern rate caps prevent out-of-control ARMs
• Can save money on short-term financing
• ARM rates can decrease, too — not just increase

Cons:

• A higher interest rate is likely during the life of the loan
• If interest rates rise, monthly payments will increase
• Higher payments can surprise unprepared borrowers

Conforming vs non-conforming ARMs

The adjustable-rate mortgages we’ve discussed so far in this article have been conforming ARMs. This means the loans conform to rules created by Fannie Mae and Freddie Mac, two quasi-government agencies that regulate the conventional mortgage market.

These rules, for example, mandate the interest rate caps we talked about above. They also prohibit prepayment penalties. Non-conforming ARMs don’t follow the same rules or feature the same consumer protections.

Non-conforming loans can offer more qualifying flexibility, though. For example, some charge interest payments only during the initial rate period. That’s one reason these loans have grown popular among real estate investors.

These loans have downsides for people buying a primary residence. If, for some reason, you’re considering a non-conventional ARM, be sure to read the loan’s fine print carefully. Be sure you understand every nuance of how the loan works. You won’t have many regulations to protect you.

Check your home buying eligibility. Start here (Apr 25th, 2024)

Adjustable rate mortgage FAQs

What is the main disadvantage of an adjustable-rate mortgage?

Uncertainty. With a fixed-rate mortgage, homeowners know up front how much they will pay throughout the loan term. Adjustable-rate borrowers don’t know how much they’ll pay for the same home after the ARM’s initial interest rate expires.

What are the pros and cons of adjustable-rate mortgages?

ARM pros include a chance to save hundreds of dollars per month while buying the same home. Cons include the fact that the lower monthly payments probably won’t last. This type of mortgage works best for buyers who can take advantage of the loan’s savings without paying more later. You can do this by refinancing or paying off the home before the interest rate adjusts.

What are the dangers of an adjustable-rate mortgage?

With an ARM, you could pay more interest payments to your mortgage lender than you expected. When the ARM’s initial interest rate expires, its rate could increase.

Is an adjustable-rate mortgage ever a good idea?

Yes, savvy borrowers can save money by getting an ARM and refinancing or selling the home before the loan’s rate potentially goes up. ARMs are not a good idea for people who want to lock in a rate and forget about it.

What is a 7/6 ARM?

The first number, 7, is the length of the ARM’s introductory rate period. The 6 means the ARM’s rate will change every six months after the intro rate expires.

ARMs: Powerful tools in the right hands

Homeownership is a big deal. If you’re new to home buying and want the simplest-possible financing, stick with a fixed-rate mortgage.

But if you’d like to maximize your borrowing power — and you have the bandwidth to monitor the interest rate market — you’ll probably like ARM financing.

Check your home buying eligibility. Start here (Apr 25th, 2024)