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Say “mortgage,” and most people think of a fixed-rate, long-term loan. While that’s certainly the most popular variety, it’s not the only home loan in town. For some aspiring homeowners, an adjustable rate mortgage might be a better option.
Adjustable-rate mortgages (ARMs) often appeal to homebuyers due to their initially low interest rates. But all good things come to an end, and you can get a nasty shock when the rate adjusts, and your monthly payments increase — often dramatically.
So it’s crucial to understand the overall pros and cons of ARMs and how they work. Forewarned is forearmed, after all.
Key takeaways
- An adjustable-rate mortgage is a mortgage with an interest rate that is locked in for a set time, then adjusts at periodic intervals.
- ARMs tend to have lower starting rates than fixed-rate loans, but can get more costly after the rate-lock period ends.
- ARMs work best for those who know they’ll sell the home after a few years or have a higher income.
How does an adjustable-rate mortgage work?
An ARM is a 30-year adjustable-rate mortgage that has an initial fixed interest rate period — three, five and seven years are especially popular. Once that period ends, the interest rate adjusts each year (or possibly six months) after that.
When this adjustment occurs, the interest that accrues on your loan is recalculated based on your principal balance and the new rate. Your new monthly payment can rise or fall along with the interest rate.
If the interest rate goes up, your payment will increase because each payment must cover the larger amount of interest that accrues. If the rate falls, the payment will decrease to account for the lower amount of accrued interest.
With each adjustment of your interest rate, the payment will adjust again, and the process will repeat each year until the loan is repaid.
Often, the rates on these loans are tied to either the yield on one-year Treasury bills, the 11th District cost of funds index (COFI) or an index called the Secured Overnight Financing Rate (SOFR).
The rate you pay will be the rate of the index at the time of the reset, plus a stated margin. For example, at the end of May 2022, SOFR was 1.05 percent. A year later, it was hovering at 5.5 percent. If the margin is 2 percentage points, the loan rate would have started at 3.05 percent (or 2+1.05) and risen to 7.5 percent.
Pros and cons of an adjustable-rate mortgage
ARMs have many benefits, including lower initial rates, but they’re not perfect for every situation.
Pros of an adjustable-rate mortgage
There are many good reasons to consider applying for an ARM, including:
- Lower initial interest rates. An ARM generally comes with a lower initial interest rate than that of a comparable fixed-rate mortgage, giving you lower monthly payments — at least for the fixed period of the loan.
- Afford a more expensive home. The lower payment can be especially attractive if you’re stretching to afford the home. The lower payment can make it easier to qualify.
- Your payment may decrease. If interest rates are falling, then your monthly payment will also fall after the initial period and during future resets. However, some ARMS have floor rates to limit how far the rate can fall.
If you’re planning to sell before the fixed-rate period is up, an ARM can be a smart move because you’ll have saved on interest.
Cons of an adjustable-rate mortgage
ARMs aren’t for everyone and there are some situations where they can be not the best option.
- Rates and monthly payments may rise. The big disadvantage of an ARM is the likelihood of your rate going up. If rates have risen since you took out the loan, your repayments will increase. Often, there’s a cap on the annual/total rate increase, but it can still sting.
- You could buy too much house. The lower initial payments could make it easier to qualify for a more expensive home. However, once that rate-lock period ends you could find yourself unable to afford the residence — or to barely make ends meet each month.
- Difficulty with refinancing. You could struggle to refinance to a fixed-rate loan if you relied on the more lenient terms and lower monthly payments of an ARM to help you qualify in the first place.
Who is an adjustable-rate mortgage best for?
Adjustable-rate mortgages can be advantageous in a few different situations.
One is when you don’t intend to stay in the home for a long time — more specifically, much beyond the fixed-rate period. For example, if you’re only going to live somewhere for five years and you get a 5/6 ARM (meaning it adjusts after the first five years), you don’t have to worry about the interest rate changing. You’ll likely have sold before that time comes.
Other groups that can benefit from ARMs are younger buyers or people at early or certain stages in their careers (in graduate school or doing a government-service stint). If you’re at a point where your income is likely to increase as you get promoted or move to a new job, you’ll find it easier to deal when the rate resets. Ideally, your rising income will offset any payment increases.
In high or rising interest rate environments, an ARM could also be a good fit. If you think rates are poised to fall eventually, you can start with an ARM to secure a lower starting rate and hope that rates have fallen by the time the rate-lock period ends. Even if there’s a rate floor, you can always refinance if rates have fallen further than your ARM will adjust downward.
Other loan types to consider
Nothing completely replaces an ARM, but here are some alternatives to consider.
- 15-year mortgages. If it’s the interest rate you’re worried about, consider a fixed-rate 15-year loan. It generally carries a lower rate than its 30-year counterpart (currently 75 to 100 basis points lower). You’ll make bigger monthly payments, but pay less in interest (and pay off your loan sooner).
- 30-year fixed mortgage. If you want to keep those monthly payments low, the good old traditional mortgage is the way to go. Nothing (else) beats the benchmark 30-year fixed loan in terms of affordable outlay — and with no worries about where interest rates are headed.
- Government-insured loans. If it’s easier terms you crave, FHA, USDA, or VA loans often come with lower down payments and looser qualifications. Some, though, have specific eligibility requirements.
