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- An adjustable-rate mortgage (ARM) is a mortgage with an initial fixed interest rate that then adjusts at periodic intervals.
- ARMs tend to have lower starting rates than fixed-rate loans, but can get more costly after the introductory period ends.
- ARMs tend to work best for those who know they'll sell the home after a few years or can afford payment jumps.
How does an adjustable-rate mortgage (ARM) work?
An adjustable-rate mortgage (ARM) is a type of mortgage with an initial fixed interest rate period, typically for three, five, seven or 10 years. Once that period ends, the interest rate adjusts at preset times for the remainder of the loan term. The most common types of ARMs adjust once every six months or once a year. A 5/6 ARM, for example, has a fixed rate for the first five years, then adjusts every six months for the rest of the term, which usually totals 30 years.
When this adjustment occurs, the interest that accrues on your loan is recalculated based on the new rate. Your new monthly payment can rise or fall along with the interest rate. With each adjustment of your interest rate, your payment will change again, and the process will repeat until the loan is repaid.
Often, the rates on ARMs are tied to 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 margin set by the lender.
Adjustable-rate mortgage pros and cons
Pros of an adjustable-rate mortgage
- Lower introductory rate and monthly payments: An ARM often 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. If you’re planning to sell before the fixed period is up, an ARM can save you a bundle on interest.
- Monthly payments might decrease: If prevailing market interest rates have gone down at the time your ARM resets, your monthly payment will also fall. (However, some ARMS have floor rates to limit how far the rate can decrease.)
Cons of an adjustable-rate mortgage
- Monthly payments might increase: The biggest disadvantage of an ARM is the likelihood of your rate going up. If rates have risen since you took out the loan, your payments will increase when the loan resets. Often there’s a cap on the rate increase, but it can still sting, and eat up more funds that you could use for other financial goals.
- Need a plan for resets: If you intend to keep the mortgage past that first rate reset, you’ll need to plan for how you’ll afford higher monthly payments long-term. If you end up with an unaffordable payment, you could default, harm your credit and ultimately face foreclosure.
Keep in mind: Your monthly payments are guaranteed to go up if you opt for an interest-only ARM. With this type of loan, you'll pay only interest for a set period of time. When that ends, you'll pay both interest and principal. This bigger bite out of your budget could negate any interest savings if your rate were to adjust down.
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. For example, if you know you’re only going to live somewhere for five years, you might opt for a 5/6 ARM, with a lower rate and payments for five years, then sell or refinance before the first rate reset.
Borrowers early in their careers who know they’ll earn more over time might also benefit from the initial savings with an ARM. Ideally, your rising income would offset any payment increases.
Other loan types to consider
- 15-year fixed-rate mortgage: 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. You’ll make bigger monthly payments, but pay less in interest and pay off your loan sooner.
- 30-year fixed-rate mortgage: If you want to keep those monthly payments low, a 30-year fixed mortgage is the way to go. You’ll pay more in interest over the longer period, but your payments will be more manageable.
- Government-backed loans: If it’s easier terms you crave, FHA, USDA or VA loans often come with lower down payments and looser qualifications.