How an ARM works
An ARM is a 30-year adjustable-rate mortgage that has an initial fixed period — three, five and seven years are popular — and then the interest rate adjusts each year (or possibly six months) after that.
When this adjustment occurs, the principal interest of your loan is recalculated going forward, and you pay the new monthly payment based on the prevailing interest rate, which could be higher or lower than the initial rate. The following year, or possibly every six months depending on the terms, your loan will adjust again, and the process will repeat each year until the loan is repaid.
These loans are tied to either the yield on 1-year Treasury bills, the 11th District cost of funds index (COFI) or a new 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, in May 2022, SOFR was 1.05 percent. If the margin is 2 percentage points, the loan rate would be 3.05 percent, or 2+1.05.
Pros of an adjustable-rate mortgage
An ARM generally comes with a lower initial interest rate than a comparable fixed-rate mortgage, giving you lower monthly payments at least for the fixed period of the loan. You’ll pay more in interest over the life of the loan if interest rates rise, but the lower initial monthly payment may be worth it.
The lower payment can be especially attractive if you’re stretching to afford the home or qualify for enough loan to cover the cost of the home, less your down payment.
If interest rates are falling, then your monthly payment will also fall after the initial period and during future resets.
If you’re planning to sell or refinance before the fixed period is up, an ARM can be a smart move because you’ll save on interest.
Cons of an adjustable-rate mortgage
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 payment will increase. ARMs typically have a limit on each reset, though. A 1 percentage point up move cap is common. There is a cap on how high the rate can go over the life of the loan.
Since the average home is sold every 13 years, a 7/1 mortgage (adjusts after the first 7 years) or 10/1 (adjusts after a decade) might make sense for homeowners who have no plans to stay in the home much beyond the fixed period of the ARM.
Another con of an ARM is that your loan terms and interest rate may at first be more lenient because of the lower monthly payments. So, if you want to refinance down the line into a fixed rate, it could be difficult to get approved for the same size mortgage loan.
The lender you’re working with will also likely require you to pass a credit check to refinance. If your credit has deteriorated since you first took out the loan, it may be impossible to get out of the original mortgage.
How to choose an ARM
When it comes to home loans, there are many options available, and an ARM is just one of them. If a lower monthly payment is a priority, consider an ARM. If having a fixed rate and knowing what your payments will be next year and the year after is important, a traditional fixed-rate mortgage might be better suited to your needs.