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Adjustable-rate mortgages (ARMs) could offer attractive rates for the first few years, but they’re often short lived. As rates fluctuate, so do your monthly payments — making it hard to budget your mortgage. Find out who these loans are best for and compare the benefits and drawbacks.
An ARM is a loan where the initial interest rate is fixed for a set period of time, then adjusts periodically based on the index it’s tied to.
Most ARMs are presented as two numbers. The first is number of years the rate is fixed, and the second represents how often the rate will adjust.
For example, a 5/1 ARM has an initial interest rate that’s fixed for five years. Once the five years is up, the rate then adjusts annually. A 7/1 ARM is fixed for seven years, then adjusts annually. During the adjustable-rate period, the interest rate can shift up or down based on the market.
These loans involve a fixed-rate period and an adjustable-rate period. The interest rate is fixed for an initial period — seven years in a 7/1 ARM, for example. After this period, the rate may adjust annually until the loan is paid off.
An I-O ARM allows you to pay only the interest portion of your loan for a set period of time, normally three to 10 years. This allows you to make smaller monthly payments over an introductory period, as you’re only paying the interest portion of the payment and not the principal. After this time, your monthly payment increases as you start paying back both the principal and interest.
This allows you to select a particular payment option each month, like a traditional payment of principal and interest, an interest-only payment or a minimum payment. A minimum payment may be less than the amount of interest due that month. Keep in mind that a minimum payment can in turn increase the amount you owe on the loan.
Generally, ARMs are best for borrowers who are:
Borrowers must understand that their rate may increase after the initial period and that this affects their monthly payments. While difficult to predict, an ARM may be useful if you believe interest rates are likely to fall in the future.
ARMs can be strong options for borrowers who only intend to keep their property for a short period of time so they can take full advantage of a lower initial rate.
This type of mortgage is suitable for borrowers who want to benefit primarily from a lower initial rate and lower monthly payments for a short-term cash flow benefit.
All adjustable-rate mortgages are tied to a base interest rate — this reference rate determines how the ARM adjusts and is known as the ARM index. Examples of index rates include the prime rate and LIBOR.
The annual cap restricts the potential increase in the ARM interest rate to a specified amount each year. This is designed to protect borrowers against a substantial increase in payments if the rates increase.
An ARM with an annual cap only increases by a certain amount regardless of how much rates actually rise. For example, a 3% ARM with a 2% cap can only adjust to 5%, even if interest rates increase by 6% during the initial fixed term of the mortgage.
The primary difference between an ARM and a fixed-rate mortgage is that the interest rate of a fixed-rate mortgage remains consistent throughout the life of the loan. With an ARM, the interest rate moves up and down in relation to an index.
Lenders also generally charge lower initial interest rates for ARMs compared to fixed-rate mortgages.
The opportunity to pay off your loan faster combined with a low initial interest rate could be attractive to many homebuyers. But if you’re not comfortable with an unpredictable interest rate, you should compare a range of home loans to find a product you like.
A margin is a fixed percentage rate that you add to your index rate to obtain the fully indexed rate for an adjustable-rate mortgage.
Yes. Though there are many reasons why you may choose to do so, some people choose this option when they expect the economy to improve in the next year or two.
Marc Terrano is a lead publisher and growth marketer at Finder. He has previously worked at Finder as a publisher for frequent flyer points and home loans, and as a writer, podcast host and content marketer. Marc has a Bachelor of Communications (Journalism) from the University of Technology Sydney. He’s passionate about creating honest and simple reviews and comparisons to help everyone get value for money.
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