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Rising mortgage interest rates have some home buyers asking whether an adjustable-rate mortgage (ARM) might be a smart, lower-cost alternative to a fixed-rate loan. An ARM typically offers a lower starting interest rate and monthly payments compared with a fixed-rate loan. The catch, however, is that your interest rate may fluctuate over the life of the loan. After an initial fixed-rate period, an ARM adjusts regularly to reflect current interest rates. When this happens, your monthly payment adjusts with it.
Getting an ARM can be a smart move if you would benefit from a lower rate and payment for the first years of your mortgage. However, it's essential to understand all of your loan terms and plan for contingencies. For many people, a fixed-rate loan is a more stable, predictable choice. To help decide whether an ARM or fixed-rate loan is best for you, here are a few ABCs of ARMs.
What Is an Adjustable-Rate Mortgage?
An ARM has an interest rate that moves up and down over the life of the loan. Unlike a fixed-rate mortgage, which has a set interest rate and monthly payment from beginning to end, an ARM adjusts at regular intervals according to your loan agreement.
ARM Terms to Know
The following terms help to explain how adjustable-rate loans work.
- Fixed-rate period: The length of time your initial interest rate and monthly payments remain the same at the beginning of your loan. Fixed-rate periods of three, five and 10 years are common.
- Adjustment period: How often your interest rate and monthly payment reset once the initial fixed-rate period is over. One year is a typical adjustment period.
- Index: Most ARMs adjust based on the one-year Treasury bill, 11th District cost of funds (COFI), London Interbank Offered Rate (LIBOR) or Secured Overnight Financing Rate (SOFR). You can track these indexes online.
- Margin: A percentage added to the index to calculate your loan's interest rate. For example, if your index is 1.5% and your margin is 2.5%, the interest rate you'll pay on your loan is 4%. While the index may move up and down, your loan's margin stays the same.
- Interest rate cap: The maximum interest rate your ARM will charge, regardless of how high the index goes.
- Payment cap: The maximum payment your loan will require, regardless of how high the index goes.
- Negative amortization: Unpaid interest that is added to your loan balance. Negative amortization happens when your required payment isn't enough to cover the amount of interest you owe.
How Much Can You Save on Interest With an ARM?
ARMs typically have lower starting interest rates than their fixed-rate counterparts. Using a snapshot of rates from July 2022, the average rate for a 30-year fixed mortgage was 5.84%, while the average starting rate for a 5/1 ARM was 4.26%. Interest on a 5/1 ARM remains fixed for five years (indicated by the 5 in 5/1) and adjusts every year after that (indicated by the 1 in 5/1). In this hypothetical example, you would save 1.58% in each of the first five years of the loan if you chose the ARM. If you're struggling to get the mortgage you need—or you'd simply like to have a lower monthly payment—an ARM can lower your debt-to-income ratio and make it easier to qualify for a loan.
How Do ARMs and Fixed-Rate Loans Compare?
When comparing an ARM with a fixed-rate mortgage, always do the math. Working out precisely how much each loan will cost you in the initial fixed-rate period—and how much you could pay if interest rates skyrocket over the years—can help you understand short-term savings versus long-term costs.
Suppose you're buying a $500,000 home with a 20% down payment. You need a $400,000 mortgage and are choosing between a 30-year fixed-rate loan and a 5/1 ARM. Using the average interest rates shown in our last section, here's how your payments might look:
|Fixed-Rate Loan||5/1 ARM|
|Monthly payment||$2,357||$1,970 (first 5 years)|
During the initial fixed-rate period, you would save $387 each month by choosing the ARM over the fixed-rate loan. That translates to a five-year savings of $23,220.
At the five-year point, the interest on your ARM would adjust. If your rate rose by 1.57% or less, you would continue to have a lower monthly payment than with the fixed-rate loan. At the opposite extreme, depending on your rate cap, your interest rate could rise by as much as 5% or more. If that happened, your new interest rate of 9.26% would mean a monthly payment of $3,688, more than double your initial payment. At that rate, the fixed-rate loan would have a lower monthly payment by $1,331—and would eventually become the cheaper option in total.
That is, of course, a worst-case scenario. Historically speaking, the likelihood that your interest rate would rise maximally and stay at that level for the remainder of your loan is fairly low. However, if you're considering an ARM, you should prepare for any eventuality. Before you agree to any loan, ask about your maximum interest rate and monthly payment—then think about how you'll afford those payments if rates hit those upper limits.
What Are the Intangible Costs?
ARMs can save you money by offering you a lower starting interest rate and, in turn, lower monthly payments. But they also require more attention and add a measure of risk. Taking out an ARM means asking a lot more questions:
- When does the loan adjust?
- What are the index and margin?
- What is the worst-case scenario for payments, interest rates and negative amortization?
Since many of these questions are unanswerable without the ability to see the future, your payments and loan balance are unpredictable. While a fixed-rate loan might cost more in those initial months, your costs are fixed forever.
When Might an ARM Be a Good Idea?
Unpredictability may be less of a concern if, for example, you plan to sell your home by the time the interest rate resets. Your interest rate and monthly payments are fixed for the initial period, so you'll have zero surprises if you sell your home before your fixed-rate period ends. There is also the chance that your rate won't increase when the time comes, or that the increase will be manageable.
When interest rates are rising, an ARM can provide home buyers with a lower-cost alternative to a fixed-rate mortgage. Beyond money savings, a lower interest rate and payment could make it easier for you to qualify for the mortgage you need.
On the other hand, if you want to buy a home so you can enjoy stable, predictable housing costs for the next three decades, an ARM might not be right for you. You may prefer to know that every mortgage payment you make will be exactly the same. If you do choose an ARM, you can refinance to a fixed-rate loan after your initial rate expires. But refinancing generally comes with closing costs and fees, and you'll need to watch interest rates so you can time your refinancing when rates are low.
The Bottom Line
Homebuyers who are challenged to qualify for fixed-rate mortgages in a rising interest rate environment may find the lower rates and payments on ARMs appealing. ARMs can also offer real savings during the initial fixed-rate period. On the other hand, the stability of a fixed-rate mortgage may be a better choice for risk-averse buyers.
If you're considering both types of loans, take the time to shop for the best rates, compare your monthly payments in a variety of scenarios, understand all of your loan terms and check your gut to see which option feels better. To improve your chances of getting a great rate on any home loan, you may want to check your credit report and score on Experian. You'll learn where your credit stands and get tips for raising your credit score―and landing a rate you can live with on your home loan.