An adjustable-rate mortgage, or ARM, is a mortgage loan that has an interest rate that changes during the term of the loan. Many adjustable-rate mortgages feature a fixed annual rate for a number of years, after which the rate can be changed at fixed intervals.
Adjustable-rate mortgages got a bad reputation during the housing crash of 2008-2009, but they can have significant advantages for certain borrowers. Adjustable-rate mortgages come in many different forms, so if you’re considering one you should understand the terms you’re being offered, their advantages and their potential risks.
What Are Fixed and Adjustable-Rate Mortgages
A fixed-rate mortgage keeps the same interest rate through the entire term of the loan. They are predictable: your monthly payment will be the same for the duration of the mortgage.
An ARM usually begins with a rate that’s lower than the rate offered for fixed-rate mortgages. After a certain number of years, the rate can change. Interest rates on ARMs don’t always go up. If the overall interest rate environment falls, they can go down. If interest rates rise, your interest rate and your monthly payment may go up.
ARMs have potential advantages in some circumstances, but they also pose risks. You should know what advantages you expect to gain and understand the risks before selecting an ARM.
How Do Adjustable-Rate Mortgages Work?
Each ARM has certain features that define when the rate can change, how often it can change and how much it can change.
- An ARM typically has a fixed-rate period, during which the rate cannot be adjusted. During this period the rate is usually lower than the rate offered for fixed-rate mortgages.
- When the fixed-rate period is over adjustments are made at intervals laid out in the loan terms, often (but not always) once a year.
- An ARM may have fixed adjustment caps. A periodic cap limits the increase in one adjustment period. A lifetime cap limits the total adjustment over the loan’s term. Some ARMs may place a cap on your monthly payment.
- Many ARMs allow a single large adjustment at the end of the fixed-rate period.
An ARM is usually described by two numbers: the number of years in the locked-in period and the frequency of adjustment after that period. A 5/1 ARM has a fixed rate for 5 years and the rate can be adjusted once each year after the 5 year period expires.
The adjustment is usually tied to an interest rate index specified in the mortgage contract. An ARM may be tied to the interest rate on Treasury Bonds or an index like the Cost of Funds Index. Your rate would be the index rate plus a set margin. For example, your interest rate might be the 10-year Treasury bond rate plus a 2% margin.
You should understand all of these figures and their possible impact on your payments before considering an ARM.
Advantages and Disadvantages of an ARM
An ARM has potential advantages that are worth considering:
- Low initial payments. During the initial fixed-rate period your payments will be lower than they would be on a fixed-rate mortgage.
- You can pay more principal. The initial low fixed interest rate could allow you to pay off more of the loan principal during that period. If you reduce that principal balance your interest payments down the line may be lower even if rates go up.
- Potential for lower rates. If the overall interest rate environment after your fixed-rate period expires is lower, you could pay even lower rates.
- Rate and payment caps. Caps on the adjustments can control the increases in your interest rate and keep your payments manageable.
An ARM also has potential disadvantages:
- Possible higher rates. Interest rates may rise significantly over time, which could lead to higher monthly payments and total interest costs.
- Potential for negative amortization. If your interest rate rises sharply and your monthly payment is capped, you could have months where you owe more after your payment than you did before it.
- Rate adjustment carryovers. If interest rates rise sharply in one year and your rate increase is capped, the balance of the rate increase can carry over to the next year, even if overall interest rates stop rising.
- Potential for a sudden change. Some ARMs allow a large rate to reset at the end of the locked-in period. If you’re not prepared, you might not be able to make the payments.
- Unpredictable monthly payments. Your monthly payment may decrease at the end of the fixed-rate period, but it could also rise. You won’t be able to predict your payments.
- Prepayment penalties. Some borrowers assume that if their rate rises, they can simply refinance with a fixed-rate mortgage. Lenders may impose a prepayment penalty that could remove any advantage from refinancing.
ARMs are more complicated and more difficult to understand. If you’re not sure that you can effectively evaluate the advantages and disadvantages of an ARM you may be better off with a fixed-rate mortgage.
When to Consider an ARM
There are certain circumstances that make an ARM worth considering:
- You are a short-term homeowner. If you have a fixed date in mind for retirement or relocation, you might intend to sell the home before the fixed-rate period ends. That could make an ARM a good deal.
- You have a rising income. If your income is limited now but you expect it to rise by the time the fixed-rate period ends, you could take advantage of the low initial rate.
- You can take advantage of falling interest rates. If you’re shopping for a home at a time when interest rates are high and expected to trend down an ARM is a logical choice.
Remember that what you plan may not happen: a planned relocation can fall through, expected salary increases might not come and interest rate trends are not always predictable. Make sure that you can meet your payments even if they rise by the maximum amount permitted by the cap.
Adjustable-rate mortgages are more complicated than fixed-rate mortgages and can involve significant risks. They can also be advantageous in certain circumstances. If you fully understand the terms of your ARM, what you intend to gain and the risks you may face, an ARM could be worth considering.