ARMs typically come with lower initial interest rates than traditional fixed-rate mortgages, making them a popular way for homebuyers to save money when fixed rates are high. However, ARMs come with an inherent risk that the loan’s monthly payment can increase when the rate adjusts.
Here’s everything you should know about adjustable-rate mortgages, from adjustment periods to interest rate caps, so you can decide if this type of home loan is right for your financial situation.
[Read: Best Adjustable-Rate Mortgage Lenders.]
How Adjustable-Rate Mortgages Work
The most popular type of adjustable-rate mortgage, a hybrid ARM, has an interest rate that stays fixed for the first few years of the loan. When the fixed-rate period expires, the rate can fluctuate periodically depending on the adjustment schedule and current market conditions. The most common example is a 5/1 ARM.
With a hybrid ARM, the first number represents the length of the fixed-rate period in years, and the second number is how often the rate can adjust (1 means once every year, while 6 means once every six months). For example, a 5/1 ARM has a fixed period of five years, and the rate can adjust once per year after that. On the other hand, a 7/6 ARM has a fixed rate for seven years, and the rate can adjust every six months once the fixed-rate period expires.
Additionally, there are a few less-common types of ARMs, including interest-only ARMs and payment-option ARMs. With an interest-only ARM, the borrower only pays the interest during the initial period, but the monthly payments rise significantly when the borrower begins to pay down the principal. Under a payment-option ARM, the borrower can select from several repayment options, but this mortgage product isn’t widely available today.
That being said, even hybrid ARMs are relatively uncommon. Just 8% of mortgages in the U.S. carry an adjustable rate, according to the Federal Reserve Bank of St. Louis. Demand for ARMs tends to pick up when interest rates are high, but the vast majority of homebuyers still opt for a fixed-rate mortgage.
Are ARMs Bad?
The Federal Reserve warns prospective ARM borrowers of “payment shock,” which can occur if a loan’s monthly payments rise sharply in a short amount of time. In fact, ARMs played a role in the 2008 housing crash, when many homeowners who couldn’t afford their newly adjusted payments went into foreclosure.
Despite their problematic past, ARMs aren’t necessarily a bad idea in today’s environment. Heightened scrutiny from regulators in the wake of the Great Recession led to tighter lending standards and more robust consumer protections. For borrowers who understand the benefits and risks, choosing an ARM can provide temporary payment relief during the first few years of homeownership.
Pros and Cons of Adjustable-Rate Mortgages
BENEFITS
— You might be able to qualify for a much lower initial rate than with a fixed-rate loan.
— Most ARM loans come with periodic and lifetime interest rate caps, in addition to payment caps.
— Hybrid ARMs come with an initial fixed-rate period that lasts between three and 10 years, giving borrowers time to sell or refinance before the rate adjusts.
DRAWBACKS
— Your interest rate and monthly payment can increase after the fixed-rate period ends.
— You might experience “payment shock” if your monthly mortgage payments increase sharply in a short amount of time.
— ARMs come with a more complicated repayment structure than traditional fixed-rate mortgages, so it may be difficult to understand the terms of your loan.
What Are Current ARM Rates?
The initial 5/1 ARM rate is usually slightly lower than the 30-year fixed mortgage rate. The interactive chart below shows current fixed and adjustable mortgage rates, per Mortgage Bankers Association data.
How Are Adjustable Mortgage Rates Determined?
ARM rates are tied to a benchmark index that fluctuates based on broader economic conditions. During an ARM’s adjustment period, lenders will determine your new rate using that index and your margin, which is the number of percentage points added to the index, as set in your loan agreement.
Index + Margin = Fully Indexed Rate
Lenders choose from a series of indexes to determine their ARM rates. For example, Wells Fargo uses its own Cost of Savings Index when setting certain ARM rates. ARM loans backed by the Federal Housing Administration may use either the Constant Maturity Treasury index or the Secured Overnight Financing Rate index, or SOFR.
The margin may vary based on factors such as the loan amount and the applicant’s creditworthiness, including their credit score and debt-to-income ratio. This means two borrowers may both have SOFR-indexed ARMs, but one borrower may have a higher margin than the other, resulting in a higher effective rate. Margins may also vary from one lender to the next, which is why it’s important to shop around with multiple lenders before formally applying for an ARM.
Adjustable Mortgage Rate Caps
Most ARMs have a rate cap structure that limits how much the interest rate can fluctuate each time the rate adjusts as well as over the duration of the loan. There are several types of rate caps that may apply to an ARM:
— Initial cap: How many percentage points the rate can increase during the first adjustment period.
— Periodic cap: How many percentage points the rate can increase in the following adjustment periods.
— Lifetime cap: How many percentage points the rate can increase (or decrease) during the life of the loan.
You might see a hybrid ARM with a 2/1/5 cap structure, for instance. The first number represents the initial cap, the second number is the periodic cap and the third is the lifetime cap. If the initial cap and the periodic cap are the same, such as in the case of a 2/2/5 rate cap structure, it may be written simply as 2/5.
Virtually all ARMs are required by law to have a lifetime cap, according to the Federal Reserve. Additionally, many ARMs — including payment-option ARMs — set a payment cap. For example, an ARM with a payment cap of 7% means that the payment can’t increase more than 7% compared with the previous payment.
[READ: 2024 Mortgage Rates Forecast: When Will Rates Go Down?]
When Is an ARM a Good Idea?
You Plan on Refinancing Before the Fixed-Rate Period Expires
Some homebuyers view an ARM as a temporary financing tool, since you can always refinance to a fixed interest rate before the adjustment period. In the case of a 5/1 ARM, there’s a good chance that fixed rates will rise and fall over the course of five years, so be ready to act when rates reach a point that you’re comfortable keeping in the long term.
Of course, mortgage refinancing isn’t free. You’ll have to pay closing costs, which are typically 2% to 5% of the loan amount and can be rolled into the outstanding balance of the mortgage. If you can secure a lower mortgage rate than what you’re currently paying, the closing costs can be offset by interest savings after a certain number of monthly payments. Be sure to find your break-even point, which is when the amount of money you save in interest is equivalent to the amount you paid to refinance.
[Read: Best Mortgage Refinance Lenders.]
You Only Plan on Living in Your Home for a Few Years
Homebuyers who plan on buying a starter home or are moving for a short-term work relocation could consider a hybrid ARM with a set fixed-rate period. As long as you plan on selling the home before the interest rate adjusts, you mitigate the risk that you won’t be able to afford higher monthly payments in the future.
Keep in mind that life doesn’t always happen as planned — you might decide to live in the home longer than originally thought, or you might have a hard time selling your home if market conditions aren’t in your favor. In that case, it’s always possible to refinance to a fixed interest rate, but you should prepare for unforeseen circumstances by making sure you can still afford your mortgage payments if your rate does rise.
You Expect an Increase in Future Earnings
An ARM might be a good option for you if you anticipate your income will increase by the time your rate adjusts. For example, a young professional who’s just getting started in their career might expect to grow their earnings as they gain more experience in the field. Or a doctoral candidate who’s a few years away from completing their degree could expect to make more money once they’ve joined a practice.
However, this situation is a bit of a gamble. It’s impossible to know for certain that you’ll be able to earn more money before your rate and monthly payments adjust, and you could be left with an unaffordable mortgage if your income doesn’t grow as expected. On the other hand, a fixed-rate mortgage comes with the security that your principal and interest payments will stay the same over the duration of the loan, making it a popular choice among homebuyers who want to err on the side of caution.
More from U.S. News
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ARM Borrowers Gamble Short-Term Savings on Long-Term Risk
As Fixed Rates Rise, Should You Consider an Adjustable-Rate Mortgage?
What Is an Adjustable-Rate Mortgage? originally appeared on usnews.com
Update 08/26/24: This story was previously published at an earlier date and has been updated with new information.
