An adjustable-rate mortgage is a loan used to purchase a home where the interest rate can change over time. An adjustable-rate mortgage, often called an ARM, differs from a fixed-rate mortgage, in which the interest rate never changes.
The initial interest rate charged on an adjustable-rate mortgage will typically be lower than the interest rate on a fixed-rate mortgage. That can make an ARM attractive, as it will reduce your immediate mortgage costs and your monthly payment.
But the interest rate charged on an adjustable-rate loan can rise over time. While an ARM's lower initial rate may be appealing, you want to give careful consideration to what you may end up paying if interest rates rise, and your ARM adjusts to a higher rate.
Is an Adjustable-Rate Mortgage Better Than a Fixed-Rate Mortgage?
Determining if a fixed- or adjustable-rate mortgage is right for you depends on your personal situation, and your appetite for financial risk. If you can afford a fixed-rate mortgage, and you want to lock in your mortgage costs for the life of the loan, a fixed-rate mortgage can be a smart option. Fixed-rate mortgages are typically more popular when interest rates, in general, are low. Adjustable-rate mortgages tend to become more popular when rates are higher.
An adjustable rate mortgage can make sense when general interest rates are high and falling; that reduces the risk that when your ARM interest rate is eligible to be "reset" it will move higher. The opposite is true when interest rates are rising, as is the case now; there is an increased likelihood that when your ARM rate is reset the new rate will be higher. If you are comfortable with the risk that your monthly payments will move higher you may want to consider an ARM.
How Does an Adjustable-Rate Mortgage Work?
The interest rate on an ARM is fixed for an initial period, during which it will not change. Adjustable mortgages that have a fixed rate for more than one year are often referred to as Hybrid ARMs as they are a mix of a fixed-rate loan (for the initial period) before the interest rate can become adjustable.
Here are 5 Types of Adjustable Rate Mortgages:
- 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 (locked) for the first 3 years, after which the rate can be adjusted once a year.
- 5/1 Hybrid ARM: The initial rate is fixed (locked) for 5 years, after which the rate can be adjusted once a year.
- 7/1 Hybrid ARM: The initial rate is fixed (locked) for 7 years, after which the rate can be adjusted once a year.
- 10/1 Hybrid ARM: The initial rate is fixed (locked) for 10 years, after which the rate can be adjusted once a year.
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 Hybrid Arm. And a 3/1 ARM will have a lower initial rate than a 5/1 Hybrid ARM.
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 two 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.
When you apply for a mortgage, a lender is required to provide you with a three-page 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.
How Is the Interest Rate on an Adjustable-Rate Mortgage Set?
There are two elements that determine the interest rate on an ARM.
- The Index: Indexes that are commonly used for ARMs include the Cost of Funds Index (COFI) and the 1-year Constant-Maturity Treasury Rate index (CMT). When an ARM is eligible for an interest rate reset, it will be adjusted if the underlying benchmark index has changed.
- The Margin: This is an extra amount that is added to the index rate. A typical margin is 2.75 percentage points or so, and usually does not change over the life of a loan. Your credit score may impact the margin you are offered on an ARM, the higher your credit scores the more leverage you may have in negotiating a lower margin.
When Does It Make Sense to Consider an Adjustable-Rate Mortgage?
Because of the lower interest rate, an ARM can make it easier to qualify for a mortgage, as you will have lower initial payments compared to a fixed-rate mortgage. That can help you pass the debt-to-income test lenders consider when reviewing your mortgage application. As a general rule, lenders like to see that your total monthly debt payments—including the new mortgage—are not more than 36% or so of your gross monthly income.
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. Buying a less expensive home you can afford with a fixed-rate mortgage could be a smart move.
If you anticipate moving before your hybrid ARM is eligible for a reset, or soon after, you can save money by choosing an ARM. For instance, if you use a 7/1 ARM and move after six years you will have saved money compared to if you had chosen a (higher rate) fixed-rate loan for those six years.
What Are the Risks of Using an Adjustable-Rate Mortgage?
If after your initial fixed-rate period, interest rates have moved higher, you will likely see your monthly payment increase.
Depending on the size of the adjustment, 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. Over the life of a loan, the maximum rate hike is typically six percentage points. There are free online calculators you can use to estimate the costs of an ARM over time, compared to a fixed-rate mortgage.
Refinancing into a fixed-rate mortgage is always an option, but if your ARM rate has moved higher, it's a good bet that that fixed-rate mortgage rates will also be higher than when you first took out your loan.
And you may find it difficult, or expensive, to refinance in the future. When you refinance, lenders evaluate your current situation. Your credit scores will once again be a major factor in whether you qualify, and the loan terms you are offered. Moreover, If the value of your home or your income has declined you may not be able to qualify for a refinance.
Where Can I Apply for an Adjustable Rate Mortgage?
An adjustable-rate mortgage is available from the same lenders that offer fixed-rate loans. That includes banks, credit unions and online lenders.
You can get a conventional loan that is an ARM, or through a government-backed mortgage from the Federal Housing Administration (FHA) and Veteran's Administration (VA).
If you decide to apply for an ARM, be extra sure to study the potential monthly costs if your interest rates rise at the first adjustment and 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.
Editorial Disclaimer: Opinions expressed here are author's alone, not those of any bank, credit card issuer or other company, and have not been reviewed, approved or otherwise endorsed by any of these entities. All information, including rates and fees, are accurate as of the date of publication.