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When shopping for a home loan, you'll have to decide which type of mortgage is right for you. The way the loan is structured is also important because it influences how much you'll ultimately pay over the life of the loan. Homebuyers can choose between a fixed-rate mortgage or an adjustable-rate mortgage (ARM).
Fixed-rate loans comprise the vast majority of mortgages, but ARMs are becoming increasingly popular among homebuyers. ARMs made up nearly 12% of mortgage applications at the end of September, according to the Mortgage Bankers Association, up from 3% in January 2022. With an ARM, your interest rate can fluctuate, pushing your monthly payment up and down as a result. But there are caps on how much it can spike.
Understanding adjustable-rate mortgage caps and different types of ARMs can help you choose the best structure for your financial situation.
How Does an Adjustable-Rate Mortgage Work?
While a fixed-rate mortgage maintains the same interest rate from start to finish, an ARM's interest rate changes periodically based on current market conditions. An ARM's loan term typically begins with a low-rate introductory fixed-interest period, after which the rate will be adjusted on a predetermined timetable.
If you're opting for an ARM, be sure to read the fine print carefully so you know what to expect. Otherwise, your budget could be in for an unwelcome surprise if your monthly payment increases. Interest rate caps put a limit on rate hikes and are categorized as follows:
- Initial cap: All ARMs begin with a fixed rate during the introductory period. When that ends and the first adjustment comes, the initial cap represents the maximum amount the interest rate can climb relative to the starting rate. This is usually 2% or 5%.
- Periodic cap: Sometimes called a subsequent adjustment cap, this limits how much the interest rate can change during all adjustment periods going forward. The typical periodic cap is 2%.
- Lifetime cap: This puts a ceiling on how much the interest rate can fluctuate during the mortgage's entire lifespan. It's usually 5%. If you have an ARM with an initial fixed rate of 5% and a lifetime cap of 5%, your rate will never be more than 10%. On the other end of the spectrum, your rate will never dip below the fixed rate, which is 5% in this case. Virtually all ARMs have a lifetime cap.
Rate caps are typically expressed as a three-digit ratio. For example, a 2/1/5 ARM would have an initial initial cap of 2%, a periodic cap of 1% and a lifetime cap of 5%. With that said, they can vary widely from lender to lender. When comparing mortgage rates, review the lender's loan estimate—it should clarify rate caps and how often the rate will change.
How Are Interest Rates Calculated for ARMs?
- The index: This is a benchmark rate that's determined by general economic trends. It's tied to an index such as the Constant Maturity Treasury (CMT) rate or the U.S. prime rate, with the specific index used varying by lender.
- The ARM margin: This is the number of percentage points the lender adds to the index following the introductory period.
After the fixed-rate period ends and you're due for periodic adjustments, the lender will add the margin to the index to calculate your new interest rate.
How to Choose Between Common Types of ARMs
After understanding rate caps and how interest rates are determined, homebuyers can choose the ARM with a rate-adjustment frequency that works best for them. This is expressed as a two-digit ratio:
- The first number indicates how long the initial fixed-interest period will last.
- The second number shows how often it will adjust after that period ends (1 means once a year; 6 means every six months).
ARM types and rate caps typically vary from lender to lender.
Common Types of ARMs
- 5/1 ARM: Fixed interest for 5 years, then the interest will adjust once every year.
- 5/6 ARM: Fixed interest for 5 years, then the interest will adjust every six months.
- 7/1 ARM: Fixed interest for 7 years, then the interest will adjust once every year.
- 7/6 ARM: Fixed interest for 7 years, then the interest will adjust every six months.
- 10/1 ARM: Fixed interest for 10 years, then the interest will adjust once every year.
- 10/6 ARM: Fixed interest for 10 years, then the interest will adjust every six months.
When comparing different types of ARMs, consider how long you plan on staying in the home. If you see it as a starter home that you're hoping to sell in a few years, a shorter fixed-rate period could make a lot of sense—especially if you can lock in a low rate. Other homeowners might prefer the predictability of a longer introductory period, though their rate could increase once that ends.
Is an ARM a Good Choice?
An ARM can be a great choice for the borrower who wants to cash in on low interest rates in the short term. They can also save homeowners money during periods when interest rates are falling. However, their inherent unpredictability might make some homeowners uneasy. You'll want to have steady income and a solid emergency fund to help you manage potentially higher monthly payments in the future.
|Adjustable-Rate Mortgage vs. Fixed-Rate Mortgage|
|Fixed-Rate Mortgage||Adjustable-Rate Mortgage|
|How interest rates work||The interest rate is fixed, meaning it stays the same for the life of the loan.||The interest rate is fixed during the introductory period and is usually lower during this time. After that, it will periodically fluctuate based on current market conditions and the loan's terms.|
|Pros||Borrowers know what to expect in terms of their monthly payment and can budget accordingly.||Borrowers can save money by taking advantage of low interest rates during the introductory period. If rates decrease after that, all the better.|
|Cons||If mortgage rates go down, borrowers will still pay their locked-in fixed rate (even if it's higher).||There's no guarantee that rates will go down in the future. If your rate increases, your monthly payment will go up too. This can make it hard to budget.|
|Who it's best for||Homeowners who prefer predictability and don't want to worry about their rate changing.||Folks who plan on selling the home before the introductory period expires. They can benefit from low rates and won't be affected by future adjustments.|
The Bottom Line
With an adjustable-rate mortgage, your interest rate will fluctuate during the life of the loan. They come in several shapes and sizes, but rate caps can give borrowers a sense of what to expect. With that said, some homeowners may prefer the consistency of a fixed-rate mortgage.