What Is an ARM Loan?
An adjustable rate mortgage (ARM) is a home loan with a variable interest rate that fluctuates based on market conditions.
The rate on an ARM loan, which typically lasts for 30 years, changes at predetermined times over the life of the loan, with limits in place to cap increases and decreases. Each ARM loan has two numbers associated with it, indicated as 7/1 ARM, for example. These indicate what the rate adjustment schedule is. The first number indicates the initial fixed-rate period, while the second number indicates how often the variable rate will update. So a 7/1 ARM loan will have the same interest rate for seven years. After that, the rate may readjust once a year through the end of the loan.
ARM loans are riskier. But if you have solid credit, secure a great rate through your lender, and can afford to pay off your mortgage before the rate changes, it might be a better option for you over a conventional mortgage.
ARM Loan vs. Fixed-Rate Loan
An ARM loan has an interest rate that changes based on the market, while a fixed-rate loan’s interest rate stays the same through the lifetime of the loan.
ARM loans are considered riskier because rates could go up dramatically — a feature that contributed to the foreclosures of the 2008 housing crisis. However, they’re attractive to borrowers when the average mortgage rate is high and they’re able to secure favorable rates through an ARM.
There are a few situations where an ARM loan could make sense over a conventional, fixed-rate mortgage. For example, an ARM loan might be more beneficial if you’re not planning on staying in your home for more than five to 10 years or you can afford to pay off your mortgage before the rate changes. Additionally, those looking to get a jumbo loan may benefit from an ARM loan because the difference between fixed and adjustable rate tends to be larger.
What Are the Different Types of ARM Loans?
There are many times of ARM loans to choose from. Here are the main ones.
- Hybrid: Offers a fixed rate for a preset time period, then becomes an adjustable rate through the end of the loan. The most common term is 5/1 — fixed for five years, then the rate changes once per year.
- Interest-only loans: For a set period of time, the borrower pays only the monthly interest on the loan and not the principal. After this period, the mortgage is amortized and your payments will increase so the loan is paid off by the end of the term.
- Option ARMs: At the beginning of the loan, you’re given four different payment options: an agreed monthly payment, an interest-only payment, a 15-year amortizing payment, and a 30-year amortizing payment. These tend to be riskier, because your payment may not cover enough to stay on track with your payoff schedule.
VA and FHA ARMs
Both VA and FHA ARM loans are backed by the federal government. Through low to 0% down-payment requirements and lenient credit standards, these loans, which offer fixed- and adjustable-rate products, are intended to create pathways to homeownership for people who otherwise wouldn’t be able to afford it. You’ll need to get these loans through approved lenders rather than through the government agencies themselves.
VA ARM loans are used by veterans and active-duty servicemembers to buy homes with 0% down and no private mortgage insurance. To get a VA loan, you need a Certificate of Eligibility (COE) to prove you qualify for the benefit, and you’ll also pay a VA funding fee during closing.
FA ARM loans are intended for low-to-moderate income families who cannot afford the traditional 20% down-payment requirement. FHA loans can require as little as 3.5% down, depending on your credit score. Credit standards for FHA loans are also more lenient compared to conventional loans. Just keep in mind that the lender will have it’s own standards you’ll have to meet as well, so make sure you have a strong financial profile and good credit before you go this route.