In a NutshellAdjustable-rate mortgages have interest rates that can change throughout the loan term. After an introductory period where the rate stays the same, the loan’s interest rate may increase or decrease in line with a benchmark rate.
An adjustable-rate mortgage, or ARM, is a home loan with an interest rate that fluctuates over the life of the loan based on market conditions.
At the beginning of the term, ARMs typically have interest rates that are lower than what you’d get with a fixed-rate loan. But they don’t last.
When the introductory interest rate period ends, the rate on the loan resets. Your interest rate and monthly payment could increase substantially — even if mortgage rates haven’t increased.
It’s important to understand how ARMs work and what types are available before determining whether this type of loan may be right for you.
- How does an adjustable-rate mortgage work?
- Types of ARM loans
- Is an ARM a good idea?
- FAQs about adjustable-rate mortgages
How does an adjustable-rate mortgage work?
Adjustable-rate mortgages have interest rates that change over the life of the loan — after an introductory period where the rate remains the same. The number of times the rate can reset — and by how much — depends on the type of ARM you have. Here’s how it works.
An index is a benchmark interest rate that increases and decreases based on market conditions. The interest rate on an adjustable-rate mortgage is tied to an index, and it fluctuates in line with the index.
A margin is the number of percentage points added to the index rate to determine the new rate on your mortgage. Like interest rates, margins vary by lender. Comparing offers from multiple lenders can help you find the lowest margin you may qualify for.
Interest rate cap
Rate changes on ARMs are capped to help prevent significant increases or decreases in the interest rate. Interest rate adjustments are typically restricted in two ways.
- An annual rate cap limits how much your interest rate can change in a year.
- A lifetime cap limits how much it can change over the life of the loan.
Conforming vs. nonconforming ARMs
Adjustable-rate mortgages can be either conforming or nonconforming loans. Conforming loans meet guidelines established by Fannie Mae and Freddie Mac — and don’t exceed loan amounts set by the Federal Housing Finance Agency, or FHFA. Because these loans comply with the agencies’ standards, lenders can sell them to Fannie Mae or Freddie Mac.
ARMs that don’t meet these guidelines are nonconforming.
Types of ARM loans
There are several common types of ARM loans to choose from. Here’s an overview of each.
3/1, 5/1, 7/1 and 10/1 ARMs
These loans have a fixed interest rate for an introductory period that may reset periodically after the initial fixed-rate period ends. The first number tells you how many years the rate is fixed.
The second number tells you how often — in this case, once per year — the rate may adjust after the introductory fixed-rate period ends.
3/6, 5/6, 7/6, 10/6 ARMs
These loans are similar to 3/1, 5/1, 7/1 and 10/1 ARMs where the first number tells you how many years the rate will remain fixed. But instead of adjusting once per year, the interest rate on these loans may adjust every six months.
Hybrid ARMs have a fixed interest rate for a set number of years at the beginning of the loan term. After that, the interest rate may adjust based on changes to the index linked to the ARM.
With an interest-only ARM, you make interest-only payments for a set time period — usually three to 10 years. The interest rate may or may not adjust during the interest-only period.
At the end of the interest-only period, you must begin making principal and interest payments. That means your monthly payments will increase even if the interest rate doesn’t.
Payment-option ARMs allow you to make different types of payments each month. For example, one month you can make a principal and interest payment, and the next month you can make an interest-only payment.
These types of ARMs may also allow you to make a limited-interest payment, which doesn’t cover the entire amount of interest due. If you make a limited-interest payment, the interest you don’t pay gets added to the principal.
If you make limited-interest payments on an ARM, you may have to make a larger one-time payment — known as a balloon payment — at the end of the loan term.
Is an ARM a good idea?
Whether an ARM is right for you depends on multiple factors, including your current and future financial circumstances, the length of time you plan to stay in your home and more.
Advantages of ARMs
- Lower initial interest rate — In general, the rate you get at the beginning of an ARM is lower than the rate you’d get with a fixed-rate mortgage.
- Potential rate decreases — If interest rates are generally decreasing, your rate may go down throughout the life of the loan.
Disadvantages of ARMs
- Teaser rates — Many lenders offer rates for the beginning of the term that are lower than the fully indexed rate. When your interest rate resets, the rate on your loan may increase even if the index rate hasn’t.
- Uncertainty — There’s no way to know for sure what your interest rate will be in the future. Your monthly payment could become unaffordable even with rate caps in place. And, because rates fluctuate, you won’t know how much interest you must pay over the life of the loan until you pay off the entire loan balance.
- Prepayment penalties — Some ARMs have prepayment penalties if you pay them off or refinance your mortgage within a certain time frame after opening the loan.
- Refinancing may be a challenge — You may not be able to refinance to a fixed-rate mortgage if the value of your home decreases or your financial situation changes.
- Balloon payments — Depending on the type of loan you have and the payments you make during the initial phase of the loan, you may owe a larger one-time payment — known as a balloon payment — at the end of the term.
If you’re trying to determine whether an ARM is right for you, asking yourself the following questions can help you decide.
- How long do you plan to stay in your home?
- Can you afford your monthly payment if the interest rate increases to the maximum amount allowed under your mortgage contract?
- What do you expect your future income to be?
- Do you plan to pay off your loan early?
- What are market conditions like? In general, are interest rates rising or falling?
- Do you plan to refinance to a fixed-rate mortgage?
FAQs about adjustable-rate mortgages
If your mortgage has an adjustable rate, it won’t stay the same over the life of the loan. It will fluctuate in line with the index that’s tied to the mortgage.
It depends on your circumstances. If you plan to move before the initial interest rate resets, then taking advantage of a lower initial rate can give you some wiggle room in your budget. But an ARM might not be your best option if you plan to stay in your home, require a stable mortgage payment or prefer predictable monthly payments.
The complexity and unpredictability of an adjustable-rate mortgage means it’s not a good fit for everyone. Your interest rate and monthly mortgage payment could increase substantially — potentially making your mortgage unaffordable. Before you get an ARM, consider the risks associated with taking on a mortgage with fluctuating rates.
Adjustable-rate mortgages typically have lower initial interest rates during the introductory fixed-rate period of the loan compared to typical fixed-rate mortgages. Depending on market conditions, your rate may decrease over the life of the loan term.