Adjustable Rate Mortgages: Know the Basics of ARMs

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When it comes to getting a mortgage, interest rate is key. It determines how much you’ll pay each month, and over the life of the loan. 

So what if it changed every year? 

That’s the premise of an adjustable-rate mortgage, or ARM. Rather than a fixed interest rate that sticks for the entire life of your mortgage, an ARM’s rate fluctuates as often as once a year, depending on the terms of your deal. 

An ARM typically starts off with a lower interest rate, compared to a fixed-rate mortgage, but the rate will eventually change based on future interest rates. With mortgage rates so low this year, leaving little room to decrease further, it’s worth questioning whether an ARM makes any sense at all.

What Is an Adjustable Rate Mortgage?

The specific terms available for ARMs are as varied as the lenders that issue them, but nearly all ARMs have a 30-year payment schedule. An ARM starts off with a low introductory rate commonly known as a “teaser rate.” Teaser rates are often lower than the rates you’ll find on comparable 30-year fixed-rate loans, but are only in effect for a limited amount of time.

An ARM’s mortgage rate changes based on the type of ARM you get. The most common ARM terms are 3/1, 5/1, 7/1, and 10/1. The first number is the number of years before the rate adjusts, and the second is the frequency (in years) for rate changes after the first one. 

Take a 5/1 ARM as an example: For the first five years it behaves like a standard fixed-rate loan, says Adam Spigelman, vice president of portfolio retention at New Jersey-based Planet Home Lending. Then, in the sixth year (and each year afterwards) the rates could go up or down depending on the index the loan is tied to and which direction rates are moving.

The fine print of an ARM will outline exactly how the new interest rate is set. The rate can go up or down based on the benchmark interest rate index the lender uses for that loan. Every ARM will have limits on how much the interest rate or payments can increase each year and over the life of the loan. 

With a fixed-rate mortgage, on the other hand, you lock in an interest rate that remains in place for the duration of the loan. 

Why ARMs Have a Dwindling Appeal in 2020

Given how low rates have been, fixed-rate mortgages make even more sense now than in the past for most homebuyers. Borrowers have increasingly gravitated toward fixed-rate mortgages, Spigelman says. The spread (difference in interest rates) between ARMs and fixed-rate mortgages is narrow, so locking in a fixed-rate mortgage with a low rate makes particular sense.

An ARM has much more room to go up than down with future rates, so the appeal of a low, long-term fixed rate is clear.  Also, with a fixed-rate loan you have more options with the loan terms. You could choose a 15-year loan over a 30-year loan and pay off your mortgage in half the time—and with less interest. 

So take a hard look at the numbers to decide if the risk associated with an ARM is worth it. To easily compare your options, you can use our mortgage calculator.

Pro Tip

If you’re getting an ARM and plan on refinancing or selling before the rate changes, be sure the mortgage doesn’t include prepayment penalties.

Is an ARM Right for You?

Determining whether or not an ARM makes sense depends on your personal situation. You’ll need to balance the potential savings with a lack of certainty because your mortgage payments could increase in the future if the rate goes up. 

If you know you’ll only be staying in your home for 5-10 years, an ARM can be more attractive. For example, for someone who expects to move before the uncertainty of future rate changes kicks in, an ARM can be more attractive because of the lower up-front interest rate and lower monthly payment. With a lower rate, you could also build equity in your home more quickly. 

Thanks to the rate and payment caps, the downside of an ARM – future rate variability – isn’t unlimited, but it’s still a serious consideration. You may plan to sell or refinance before the rate changes, but things don’t always go to plan. 

If rates go up overall, refinancing might still increase your mortgage rate or monthly payment. Not to mention, if your financial situation takes a turn for the worse and your credit score or home value decreases, you could find it more difficult to qualify for a mortgage refinance or to buy a different home. 

Also, some ARMs may include prepayment penalties, so if you plan to pay off your loan early, be sure to ask your lender if these fees are included.

In short, ARMs are more risky, but the reward is upfront savings during the introductory rate period.