When you get a mortgage, you can choose a fixed rate or one that changes. While fixed-rate mortgages keep the same interest rate for the life of the loan, adjustable-rate mortgages, or ARMs, have fluctuating rates.
What is an adjustable-rate mortgage?
An adjustable-rate mortgage, or ARM, is a home loan with an interest rate that can change periodically. This means that the monthly payments can go up or down. Generally, the initial interest rate is lower than that of a comparable fixed-rate mortgage. After that period ends, interest rates — and your monthly payments — can go lower or higher.
Interest rates are unpredictable, though in recent decades they’ve tended to trend up and down over multi-year cycles. Although rates are expected to increase this year, they’re still relatively low, historically speaking, making fixed-rate mortgages the more prevalent option for now. ARMs are mostly best for borrowers who don’t plan to stay in a home long-term.
How do ARMs work?
The most popular adjustable-rate mortgage is the 5/1 ARM:
- The 5/1 ARM’s introductory rate lasts for five years. (That’s the “5” in 5/1.)
- After that, the interest rate can change every year. (That’s the “1” in 5/1.)
You’re insulated from possible steep year-to-year increases in monthly payments because ARMs come with caps limiting the amount by which rates and payments can change:
- A periodic rate cap limits how much the interest rate can change from one year to the next.
- A lifetime rate cap limits how much the interest rate can rise over the life of the loan.
- A payment cap limits the amount the monthly payment can rise over the life of the loan in dollars, rather than how much the rate can change in percentage points.
Types of ARMs
- Hybrid ARM – A hybrid ARM is the traditional adjustable-rate mortgage. The loan starts with a fixed interest rate for a few years (usually three to 10), then the rate adjusts up or down on a preset schedule, such as once per year.
- Interest-only ARM – Interest-only ARMs are adjustable-rate mortgages with which the borrower only pays interest (no principal) for a set period. Once that interest-only period ends, the borrower starts making full principal and interest payments. The interest-only period might last a few months to a few years. During that time, the monthly payments will be low (since they’re only interest), but the borrower also won’t build any equity (unless the home appreciates in value).
- Payment-option ARM – With a payment-option ARM, borrowers select their own payment structure and schedule, such as interest-only; a 15- 30- or 40-year term; or any other payment equal to or greater than the minimum payment. (The minimum payment is based on a typical 30-year amortization with the initial rate of the loan.) A payment-option ARM, however, could result in negative amortization, meaning the balance of your loan increases because you aren’t paying enough to cover interest. If the balance rises too much, your lender might recast the loan and require you to make much larger, and potentially unaffordable, payments.
How variable rates on ARMs are determined
Most ARM rates are tied to the performance of one of three major indexes:
- Weekly constant maturity yield on one-year Treasury bill – The yield debt securities issued by the U.S. Treasury are paying, as tracked by the Federal Reserve Board
- 11th District cost of funds index (COFI) – The interest financial institutions in the western U.S. are paying on deposits they hold
- The Secured Overnight Financing rate (SOFR) – The SOFR has replaced the London Interbank Offered Rate as the benchmark rate for ARMs
Your loan paperwork identifies which index a particular ARM follows.
To set ARM rates, mortgage lenders take an index rate and add an agreed-upon number of percentage points, called the margin. The index rate can change, but the margin does not.
For example, if the index is 1.25 percent and the margin is 3 percentage points, they are added together for an interest rate of 4.25 percent. If, a year later, the index is 1.5 percent, then the interest rate on your loan will rise to 4.5 percent.
Pros and cons of ARMs
- Lower initial interest rate, translating to lower monthly payments and the potential to allocate more money toward principal
- Interest rate and monthly payments might decrease
- Interest rate can’t rise beyond the cap limit
- Interest rate and monthly payments might rise, and to an unaffordable level, even with the cap limit
- More complex structure that could be difficult to understand
- Potential for a prepayment penalty
Is an adjustable-rate mortgage right for you?
Adjustable-rate mortgages trade long-term certainty for upfront savings by providing a lower interest rate for the first years of your loan. They’re generally ideal for borrowers who don’t plan to stay in their home long-term or plan to refinance after a few years. If you’re going to stay in your home for decades, an ARM can be risky — you might find your mortgage payments rising by a significant amount once the fixed-rate period ends. If you’re buying your forever home, think carefully about whether an ARM is right for you.