What is an adjustable-rate mortgage?
An adjustable-rate mortgage (ARM) is a home loan that offers a low interest rate for a pre-set period, typically anywhere from 3 to 10 years. When that period is finished the loan’s rate adjusts based on changes in overall interest rates — though in most cases, “adjusts” means the rate increases.
Adjustable-rate mortgages can offer a good deal for some buyers — depending on their home buying goals, their specific financial circumstances, and overall market conditions. Below, we’ll explore how an adjustable-rate mortgage works and when it makes sense.
Fixed-rate vs adjustable-rate mortgage: Which is better?
Understanding the differences between a fixed-rate mortgage and an adjustable-rate mortgage can help you determine which loan is right for you. So, let’s take a closer look at how these loans work.
A fixed-rate mortgage is a home loan that lets you permanently lock in your interest rate for the entirety of the loan term. As a result, your monthly payment will stay the same over the life of the loan. Fixed-rate mortgages typically span from 15 to 30 years. They’re good if you’re looking for a consistent mortgage payment. They’re also a good option if you’re planning to own your home for a while.
An ARM, on the other hand, is an entirely different type of mortgage loan product.
How does an adjustable-rate mortgage work?
An ARM has a lower interest rate than a fixed-rate loan — and, as a result, a lower mortgage payment — for a predetermined initial period. When that initial period ends, the rate can fluctuate depending on the current conditions of the mortgage market.
ARM rates and rate caps
Typically, ARMs have significantly lower mortgage rates during their introductory period than rates for fixed loans. As of August 18, the average 5-year ARM offers an introductory rate that’s roughly a whole point lower than the average fixed interest rate for a 30-year mortgage.
There are caps, however, that limit how high the new rate can go on. There are three types of interest rate caps: an initial cap adjustment, a subsequent cap adjustment, and a lifetime cap adjustment.
The initial cap adjustment is the most that your rate can rise the first time that it adjusts. The subsequent cap adjustment sets a limit on the most that the rate can increase in a single adjustment period after the initial adjustment. And the lifetime cap is how high the rate can increase over the life of the loan.
ARM caps are set by mortgage lenders. They’re typically presented in a series of three digits, such as 2/2/5, that represent each cap: the initial cap (2), the subsequent cap (2), and the lifetime cap (5). Most ARMs follow a 2/2/5 structure or a 5/2/5 structure, according to the Consumer Financial Protection Bureau.
For instance, if you have an ARM with a 2/2/5 cap, your rate cannot change by more than:
- 2% when the fixed-rate period ends
- 2% for each adjustment period
- 7% over the life of the loan
Imagine your initial ARM interest rate is 3%. With these caps in place, your rate could not go higher than 5% at its first adjustment; it could not increase by more than two percentage points at any subsequent adjustment; and it could not go higher than 7% over the life of the mortgage loan.
Refinancing an ARM
An ARM can be refinanced to a fixed-rate mortgage at any time. That offers a nice safety cushion for buyers who decide they’d like to stay in their home longer than they originally planned.
Refinancing an ARM entails replacing your existing loan with a new mortgage. You’ll typically want to refinance your ARM (or sell your home) before the ARM’s introductory period ends, especially if interest rates are higher at that time. When you apply for a refinance, the lender’s underwriter will analyze your income, credit score, assets, and debts to determine your eligibility for a new loan.
When refinancing, expect to pay 2% to 5% of your loan principal in closing costs. For, a $300,000 mortgage, your closing costs for refinancing could run from $6,000 to $15,000.
Different types of ARM loans
Generally, there are three kinds of ARMs: hybrid, interest-only, and payment option.
A hybrid ARM offers an initial fixed interest rate that then adjusts, usually once per year. The initial period typically lasts 3, 5, 7, or 10 years. Most modern ARM loans are hybrid ARMs.
An interest-only (IO) ARM is a loan where the borrower is only required to pay the interest portion of the mortgage for a pre-set period of time — also typically 3 to 10 years. Interest-only payments don’t pay down your mortgage principal.
A payment option (PO) ARM is an adjustable-rate loan that offers several payment choices: paying an amount that covers both the loan’s principal and interest, paying an amount that covers only the loan’s interest, or paying a minimum (or limited) amount that may not even cover the loan’s monthly interest.
Pros & cons of an ARM mortgage
Pros of an adjustable-rate mortgage
The benefits of getting an adjustable-rate loan are that it:
- Creates short-term savings through a low initial mortgage rate
- Works well for temporary homes
- Makes homes more affordable
- May enable you to borrow more money
Cons of an adjustable-rate mortgage
The drawbacks of an ARM are:
- It’s more complex than a fixed-rate loan
- Payments can increase a lot after the initial rate expires
- It makes budgeting more difficult
Qualifying for an ARM
To be eligible for an adjustable-rate mortgage, you typically must have:
- At least a 5% down payment (note: FHA ARMs require only 3.5% down payments)
- A credit score of at least 620
- A debt-to-income ratio (DTI) of no more than 50%
- A loan-to-value ratio (LTV) of no more than 95%
When does an ARM mortgage make sense?
An ARM may be a good fit if you’re a first-time buyer purchasing a starter home that you know you’re going to sell before the introductory period is over, an investor flipping a house, or feel comfortable with payment fluctuations and potentially absorbing higher rates and higher mortgage payments in the future.
What is an ARM mortgage? FAQs
What is an ARM?
An adjustable-rate mortgage (ARM) is a loan that offers a low interest rate for an initial period, typically anywhere from 3 to 10 years. When the introductory rate expires, the interest rate adjustment means your monthly payment can fluctuate depending on mortgage market conditions.
Why would you choose an ARM?
It may make sense to get an ARM instead of a fixed-rate mortgage if you’re planning to sell the home before the introductory rate period ends, flipping a house short term, or need a low introductory rate to afford a home purchase.
How does an ARM work?
An ARM is a type of loan that offers a low interest rate for a predetermined number of years, typically anywhere from 3 to 10 years. But when that introductory period is over the loan’s rate can adjust depending on changes in overall mortgage rates.
Are ARM rates lower than fixed rates?
Typically, yes — and the difference can be substantial. As of August 18, the average 5-year ARM offered a 4.39% introductory rate, according to Freddie Mac. That week the average rate for a 30-year fixed-rate mortgage was 5.13%.
Is a 7-year ARM a good idea?
A 7-year ARM might be a good way to save money if you know that you’re going to sell the home within the first 7 years.
What are basis points and how do they relate to ARMs?
A mortgage basic point, or “discount point,” is a fee that you pay at closing to your lender—typically 1% of your loan amount—in exchange for a lower interest rate, usually by around 0.25% (25 basis points). Purchasing basis points for an ARM can lower your introductory interest rate, making your monthly mortgage payment more manageable.
Are there limits on how high ARM interest rates can go?
Adjustable-rate mortgages have caps on how high the interest rate can go after the introductory rate expires. These rate caps are set by lenders.
What is the fully indexed rate on an ARM?
The fully indexed rate is the highest possible interest rate that you’d pay when your ARM’s introductory rate period ends. This figure is calculated by adding the index (whatever that happens to be when your initial rate expires) and a margin (usually 1.75% for Fannie Mae or Freddie Mac loans).