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An adjustable-rate mortgage, often called an ARM, is a home loan where the interest rate can change over time after an initial fixed period. This arrangement differs from a fixed-rate mortgage (FRM), where the interest rate stays the same for the life of the loan.
ARMs can be appealing due to the lower fixed rate they provide during the first few months or years of the loan term. However, changing interest rates can pose a long-term risk to borrowers who don't refinance or sell their home before the fixed period expires. Here's what to know before you borrow.
How Does an Adjustable-Rate Mortgage Work?
The interest rate on an ARM is fixed for an initial period, typically at a lower rate than a comparable FRM. After that period ends, the rate fluctuates with the current market rates.
During the variable-rate period, your interest rate will change every six or 12 months based on an underlying benchmark, such as the Secured Overnight Financing Rate or the prime rate, and a margin set by the lender.
Adjustments to your interest rate are typically capped during the initial adjustment and subsequent adjustments. There's also usually a lifetime cap on how much your rate can go up or down.
Types of Adjustable-Rate Mortgages
There are several types of ARMs, each of which has a different initial fixed period and adjustment period. The most common options, typically called hybrid ARMs, include:
- 5/1 ARM: The initial rate is fixed for the first five years, after which the rate can be adjusted once a year.
- 10/1 ARM: The initial rate is fixed for 10 years, after which the rate can be adjusted once a year.
- 5/6 ARM: The initial rate is fixed for five years, after which the rate can be adjusted once every six months.
- 7/6 ARM: The initial rate is fixed for seven years, after which the rate can be adjusted once every six months.
- 10/6 ARM: The initial rate is fixed for 10 years, after which the rate can be adjusted once every six months.
Some lenders offer specialized types of ARMs, such as:
- Payment option ARMs: With this type of loan, you can choose how to repay your loan based on your budget. That may include interest-only payments, full principal and interest payments or minimum payments.
- Interest-only ARMs: With this option, you'll pay only the interest that accrues in your loan for a predetermined time period, after which you'll need to make principal and interest payments.
How Much Can an Adjustable-Rate Mortgage Change?
Once your initial fixed period is over, your interest rate can change every six or 12 months, but there are caps on how much the rate can change with each adjustment:
- Initial rate cap: After the initial period, the first adjustment is often capped at a maximum of 2 percentage points, though it can be as much as 5 percentage points.
- Periodic rate cap: Subsequent rate adjustments are typically limited to 2 percentage points per adjustment period.
- Lifetime rate cap: The lifetime cap is typically 6 percentage points or so above the initial interest rate.
While these figures are typical, 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 be charged.
Adjustable-Rate Mortgage vs. Fixed-Rate Mortgage
Fixed-rate mortgage loans tend to be more popular than adjustable-rate mortgages because they offer more predictability. In fact, just 7.5% of mortgage applications in late December 2022 were for ARMs, according to the Mortgage Bankers Association.
However, there are advantages and disadvantages to consider for both loan options. Here's a quick summary to help you compare your options:
- Interest rates: ARM rates typically start out lower than FRM rates for the initial period. After that, though, your rate can go up or down based on market conditions, whereas FRM rates remain the same for the life of the loan.
- Total interest cost: With an FRM, you know your total interest costs upfront, but that's not the case with ARMs. While an ARM can save you money with a lower rate during the initial period, your total costs can be higher if market rates go up over time.
ARMs tend to be more appealing when interest rates are high because of their lower initial rate. Many borrowers opt for an ARM with the hope that interest rates will go back down and they can refinance their loan at a lower fixed rate before their initial period ends.
If rates increase, though, ARM borrowers may have difficulty keeping up with their monthly payments.
How to Qualify for an Adjustable-Rate Mortgage
Each lender has its own approach to underwriting criteria, but in general, ARM requirements are similar to the guidelines for FRM loans. Standard guidelines include:
- Credit score: For a conventional ARM, you typically need a score of 620 or above to get approved, but Federal Housing Administration (FHA) ARMs can go as low as 580 or even 500 if you have a 10% down payment. Veterans Affairs Administration (VA) ARMs don't have a minimum score set by the VA, but lenders typically look for a 620 or higher.
- Debt-to-income ratio: You'll typically need a debt-to-income ratio (DTI) of no more than 50%, though the lower it is, the better your chances of approval and a low interest rate.
- Down payment: For a conventional ARM, you'll typically need to put down 5%, though some lenders may offer lower requirements. With an FHA ARM, you can put down as little as 3.5%, and VA ARMs require no down payment at all.
Lenders will also consider your credit history, cash reserves and other factors to determine your eligibility.
Pros of an Adjustable-Rate Mortgage
There are several benefits to getting an ARM over an FRM, particularly during periods of high interest rates. Here are some advantages to consider.
Lower Upfront Payments
With a lower initial fixed interest rate, homeowners can save some money for the first several years living in their home. This can be especially helpful if your DTI would be too high with an FRM or interest rates are generally high.
If you're not certain how long you're going to stay in your current home, an ARM allows you to take advantage of lower monthly payments without needing to make a decision right now. If you sell your home before the fixed period ends, you don't have to worry about fluctuating interest rates. And if you decide to stay, you can refinance your loan into a fixed interest rate.
Interest Rates Can Go Down
If interest rates are high, there's a possibility that they'll go down instead of up by the time your fixed period expires. If this happens, you'll enjoy a lower interest rate and monthly payment than before.
Cons of an Adjustable-Rate Mortgage
While there are some benefits to using an ARM instead of an FRM, you're ultimately the one taking on the risk of rising interest rates. Here are some potential pitfalls to keep in mind.
Your Payments Can Go Up
While there are limits on how much your interest rate can increase, a higher monthly payment can put undue stress on your budget, making it more difficult to keep up with your obligations and other necessary expenses.
Refinancing Isn't Cheap
If your goal is to refinance your ARM before the fixed period ends, that decision could save you money in the long run, but it'll cost you upfront. Mortgage closing costs can range from 2% to 5% of the loan amount. On a $300,000 loan, that's between $6,000 and $15,000 that you'll have to pay out of pocket or roll into your new loan.
Unless you stay in the home for a long period, that cost may not be worth it.
ARMs can have incredibly complex terms that are hard to follow if you're not familiar with them. If you don't understand what you're getting yourself into, you could end up with an unfortunate surprise when your rate adjusts.
How an Adjustable-Rate Mortgage Could Impact Credit
On its own, an ARM won't impact your credit any differently than an FRM. In general, though, there are some key ways it can affect your credit file:
- Credit inquiry: When you apply for the loan, the lender will run a hard inquiry, which can impact your credit score, albeit temporarily.
- New account: When you add a new credit account to your credit reports, it'll affect your length of credit history.
- Payments: As you make on-time payments, an ARM can help you build your credit score. However, missed payments can hurt your credit. If you experience a sudden increase in your interest rate at the end of the initial fixed period or after that, it could increase your chances of not being able to afford your payment.
How to 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 through FHA and VA programs. Take some time to research all of your options to ensure that you get the best rate you qualify for.
Improve Your Credit to Score a Lower Rate
An ARM can provide a lower initial 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 report 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.