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Guide to adjustable-rate mortgages
You could take advantage of a lower initial rate, but be wary of the market risks.
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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.
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What is an adjustable-rate mortgage?
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.
How does an ARM work?
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.
What are the pros and cons for ARMs?
Pros
- Lower initial rate. The initial interest rate of an ARM is generally lower compared to a fixed-rate mortgage. This can be beneficial if you only plan to stay in your home a few years, or plan on refinancing before the adjustment period starts.
- Rate cap protection. Many ARMs have an interest rate cap which places a limit on how much the interest rate can increase, protecting you from steep rate increases.
- Pay down loan faster. If you’re in a position to pay more toward the principal balance of your loan, an ARM’s often-lower rates may leave enough breathing room to do so.
Cons
- Market risk. After the fixed-rate period ends, the interest rate can rise and your monthly payments can become more expensive.
- Difficult to budget. As interest rates are unpredictable, you can’t predict what your monthly payments will be after the initial period.
- Complexity. The structure of ARMs can be difficult to understand for many borrowers when considering the margin, caps, indexes and fees. Some borrowers may find it difficult to effectively compare ARMs.
What are the different types of ARMs?
Hybrid ARMs.
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.
Interest-only (I-O) ARMs.
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.
Payment-option ARM.
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.
Who are ARMs best for?
Generally, ARMs are best for borrowers who are:
Comfortable with a degree of risk.
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.
Holding property for a short period.
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.
In need of short-term cash flow.
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.
What is an ARM index?
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.
What is the annual cap?
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.
What’s the difference between an ARM and a fixed-rate 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.
Bottom line
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.
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