What Is an Adjustable-Rate Mortgage?

What Is an Adjustable-Rate Mortgage? article image.

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An adjustable-rate mortgage, often called an ARM, is a home loan where the interest rate can change over time. This setup differs from a fixed-rate mortgage, where the interest rate stays the same for the life of the loan.

How Does an Adjustable-Rate Mortgage Work?

The interest rate on an ARM is fixed for an initial period, during which it won't change. After that period ends, the rate fluctuates with limits based on the current market rates. A true ARM has a fixed interest rate for just one year.

There are, however, hybrid ARMs that offer longer introductory periods where the interest rate is fixed.

Types of Adjustable-Rate Mortgages

Here are five common types of adjustable-rate mortgages you may see when shopping around for a loan:

  • 1-year ARM: The initial rate is fixed for 1 year, after which the rate can be adjusted once a year.
  • 3/1 hybrid ARM: The initial rate is fixed for the first 3 years, after which the rate can be adjusted once a year.
  • 5/1 hybrid ARM: The initial rate is fixed for 5 years, after which the rate can be adjusted once a year.
  • 7/1 hybrid ARM: The initial rate is fixed for 7 years, after which the rate can be adjusted once a year.
  • 10/1 hybrid ARM: The initial rate is fixed for 10 years, after which the rate can be adjusted once a year.

In general, the shorter the initial fixed-rate period, the lower the initial rate will be. For instance, the initial rate on a 1-year ARM will be lower than the initial rate on a 3/1 ARM, and a 3/1 ARM will have a lower initial rate than a 5/1 ARM. This is because the longer the lender keeps the initial rate fixed, the more risk it takes that interest rates will rise during that time.

How Much Can the Interest Rate Change on an Adjustable-Rate Mortgage?

After the initial period, the first reset is often capped at a maximum of 2 percentage points, though it can be as much as 5 percentage points. Subsequent rate adjustments are typically limited to 2 percentage points a year.

There is also a lifetime rate cap; this is the total maximum rate increase that can be charged over the life of the loan. The lifetime cap is typically 6 percentage points or so above the initial interest rate. While these figures are typical, though, they're not set in stone.

When you apply for a mortgage, a lender is required to provide you with a loan estimate that spells out the various costs and features of the loan. If you are applying for an ARM, the loan estimate will include the maximum pay increase you will owe at the first adjustment, how often the rate can be adjusted, and the maximum monthly payment you could ever be charged.

Adjustable-Rate Mortgage vs. Fixed-Rate Mortgage

The initial interest rate charged on an adjustable-rate mortgage will typically be lower than the interest rate on a fixed-rate mortgage, primarily because the lender is taking on less risk. That difference can make an ARM attractive because it reduces your monthly payment immediately.

But because the interest rate charged on an adjustable-rate loan can rise over time, it can ultimately cost more money in the long run if you're not careful.

If you're trying to decide between a fixed- or adjustable-rate mortgage, the right option for you depends on your situation and appetite for financial risk.

For example, if you'd prefer to lock in your monthly payment for the life of the loan and can afford the higher payment amount, a fixed-rate mortgage may be the better choice. That's especially the case when interest rates are relatively low, and you have the chance to nail down an initial low rate.

On the other hand, an adjustable-rate mortgage can make more sense when mortgage interest rates are relatively high. By taking advantage of a lower interest rate now, you can score a lower monthly payment and hope interest rates drop by the time your initial period ends. That said, you're taking the risk that interest rates may not decrease, which could result in a higher monthly payment after the initial period ends.

Who Qualifies for an Adjustable-Rate Mortgage?

From a creditworthiness standpoint, getting an adjustable-rate mortgage isn't more difficult than getting a fixed-rate loan. In some ways, in fact, you may qualify for the former and not the latter.

Because an ARM has a lower monthly payment, it can make it easier to qualify based on debt ratios mortgage lenders use. For example, it's common for a lender to require that your monthly housing payment not exceed 28% of your gross income.

If a fixed-rate mortgage with a higher interest rate and monthly payment exceeds that amount, you may be able to qualify by switching to a lower payment on an ARM.

When Is an Adjustable-Rate Mortgage a Good Idea?

There are a few situations where it may be worth considering an ARM over a fixed-rate mortgage. Here are some of the more common ones:

  • To meet debt ratio requirements: Getting an ARM can help you pass the debt-to-income (DTI) test lenders consider when reviewing your mortgage application.
  • Interest rates are high: If you have good reason to believe that interest rates are high and may come down, it may not make sense to lock yourself into a high rate. With an ARM, your interest rate can go down over time as market rates change.
  • You're planning on refinancing: If interest rates decrease significantly during your initial fixed-rate period, you may opt to refinance your loan at the lower rate rather than risking it going back up again on your ARM.
  • You're anticipating a move: The average homeowner stays in their home for just over eight years, according to ATTOM Data Solutions. But if you think you won't outlast your ARM's initial fixed period, it may make more sense to take the lower monthly payment and save money. If your plans change, though, it could end up costing you more over time.

If you are approved for an ARM, be sure to carefully consider whether you will be able to handle higher payments in the event your ARM eventually adjusts higher. Otherwise, the risk could ultimately force you to sell the home or even default on the loan.

Are There Risks When Using an Adjustable-Rate Mortgage?

The primary risk of an ARM is that your monthly payment can increase after the initial fixed-rate period. Depending on the size of the adjustment that first year, you may still come out ahead with an ARM after the initial period.

But remember that the interest rate can be adjusted in the following years as well, up to a maximum rate cap. If interest rates continue to rise, you could end up paying a lot more in interest than if you had chosen a fixed-rate mortgage initially.

Refinancing into a fixed-rate mortgage is always an option. Keep in mind, though, that if your ARM rate has moved higher, it's likely that fixed-rate mortgage rates will also be higher than when you first took out your loan.

Even so, it's possible that you might not qualify to refinance at all. When you apply for a refinance loan, lenders will evaluate your current situation, not the situation when you first bought the house.

Your credit scores will once again be a major factor in whether you qualify, and in the loan terms you are offered. What's more, if the value of your home or your income has declined, you may not be able to qualify for a refinance.

How an Adjustable-Rate Mortgage Could Impact Credit

The type of loan itself doesn't impact your credit any differently than a fixed-rate mortgage. However, seeing a sudden increase in your monthly payment at the end of the initial fixed period or after that can cause it to become unaffordable.

If that happens and you miss payments, it could hurt your credit score. If you miss multiple payments, the lender could choose to foreclose on the house, causing even more damage than the initial missed payments.

On the flip side, making your payments on time every month can establish a positive payment history, which can help improve your credit score over time.

Where Can I Apply for an Adjustable-Rate Mortgage?

An adjustable-rate mortgage is generally available from the same lenders that offer fixed-rate loans, including banks, credit unions and online lenders.

You can get an ARM as a conventional loan or as a government-backed mortgage from the Federal Housing Administration (FHA) and Veterans Administration (VA). Take some time to research all of your options to ensure that you get the best rate you qualify for.

Also, make sure you study the potential monthly costs if your interest rate rises at the first adjustment and at subsequent adjustments. Given the big financial commitment of a mortgage, it's smart to consider these what-ifs.

If those potentially higher monthly payments make you nervous, a fixed-rate mortgage may be your better option.

Improve Your Credit to Score a Lower Rate

An ARM can provide a lower interest rate than a fixed-rate mortgage. But if your credit isn't in great shape, your rate will still be higher than what you could qualify for with a better credit score.

Check your credit score to find out where you stand, and get a copy of your credit reports from AnnualCreditReport.com to determine which areas you may need to address. If you're not in a hurry, take some time to work on improving your credit before you start the mortgage preapproval process. It can take time to build your credit, but doing so could save you thousands, if not tens of thousands, of dollars over the life of your mortgage loan.

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