Adjustable-rate mortgages: Learn the basics of ARMs
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When you get a mortgage, you can choose a fixed rate or one that changes. While fixed-rate mortgages keep the same interest rate and payment for the life of the loan, adjustable-rate mortgages, or ARMs, have fluctuating rates that change how much you pay.
- Adjustable-rate mortgages (ARMs) come with an interest rate that changes at predetermined times, such as once a year. The rate can go up or down depending on economic factors.
- ARMs typically have a low introductory rate, which translates to more affordable monthly mortgage payments initially.
- ARMs are generally better for borrowers who plan to stay in the home for a shorter time, or who expect to refinance before the introductory rate period ends.
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. Given the recent increase in rates, ARMs can help you save money in the early days of your loan by securing a lower initial rate.
Just keep in mind that after the first few years of the loan, the rate – and your monthly payment – might go up.
The initial interest rate on an adjustable-rate mortgage is sometimes called a “teaser” rate, and even ARMs themselves are sometimes referred to as “teaser” loans. While they’re generally one and the same, there can be a difference between a regular ARM and a riskier teaser loan that offers an extremely discounted rate upfront, followed by a dramatic increase or decrease in rate.
How do ARM loans work?
The most popular adjustable-rate mortgage is the 5/6 ARM, which has replaced the 5/1 ARM:
- For both 5/1 and 5/6 ARMs, the introductory rate lasts for five years. (That’s the “5” in 5/6.)
- After that, the interest rate can change every six months, or every year. (That’s the “6” in 5/6, or the “1” in 5/1.)
Some lenders offer 3/1 ARMs, 7/1 ARMs and 10/1 ARMs.
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
There are three main types of ARMs, hybrid, interest-only, and payment-option.
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 ARMs are adjustable-rate mortgages in 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).
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 (LIBOR) 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
- The lower monthly payment gives you more budget flexibility. You could choose to pay more when you have extra cash, and less when you need money for other things.
- 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. Bankrate’s ARM calculator can help you decide whether this type of loan is the best choice.