Everything Homebuyers Need to Know

Ultimate Guide to Adjustable-Rate Mortgages

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ByChristopher Boston
Reviewed byTimothy Manni
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ByChristopher Boston
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Reviewed byTimothy Manni
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Updated: December 12, 2023

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A mortgage is a loan homeowners use to purchase property or land, providing financing for amounts they can't pay upfront. Unlike auto or personal loans, mortgages are typically secured by the property itself, allowing lenders to repossess and sell it to recover funds if payments are not maintained.

One significant category in home financing is the adjustable-rate mortgage (ARM). Unlike a fixed-rate mortgage, an ARM features an interest rate that can change over time, distinguishing it from the stable rates of fixed-rate mortgages.

Before purchasing a home, it’s important to assess various financing options and select the one that best aligns with your financial goals. Your chosen mortgage type will significantly shape your long-term financial health, impacting monthly payments and the amount you’ll pay over the life of the loan.

What Are Adjustable-Rate Mortgages?

An adjustable-rate mortgage (ARM) is a home loan, and, as its name implies, its interest rate can change over time. That’s what sets it apart from another common type — a fixed-rate mortgage, which has a stable interest rate throughout the term of the loan. Here are the primary components that define how an ARM works:

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    Initial Fixed-Rate Period

    An ARM typically starts with a fixed rate period, where the interest rate does not change. This period can range from a few months to several years, offering short-term predictability in your mortgage payments.

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    Adjustment Intervals

    After the initial fixed-rate period, the ARM's interest rate changes at regular intervals. These adjustment intervals can be annually, semi-annually or even monthly, depending on the mortgage terms.

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    Index

    The index is a benchmark interest rate that fluctuates based on market conditions. The most common indexes include the Secured Overnight Financing Rate (SOFR), the U.S. Prime Rate and Treasury rates.

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    Margin

    The margin is a fixed percentage that is added to the index rate to determine the total interest rate of your ARM.

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    Caps

    Caps restrict how much interest rates or monthly payments can increase at each adjustment period ("periodic caps") and over the loan's duration ("lifetime caps"). These protect borrowers from excessive increases in their interest rate and monthly payment.

Types of Adjustable-Rate Mortgages

Several types of ARMs are available, each with different characteristics that can affect your interest rate and monthly payments. In each ARM, the number before the slash represents the initial fixed-rate period's duration (in years). The number after the slash indicates how often the rate adjusts after the initial period. For example, in a 5/1 ARM, the rate is fixed for five years and then adjusted yearly.

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    3/1 ARM

    In a 3/1 ARM, the interest rate is fixed for the first three years and then adjusted every year after that. This type of mortgage may be suitable for those who plan to sell or refinance their home within a few years.

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    5/1 ARM

    This mortgage offers a fixed rate for the first five years. After that, the rate adjusts every year. A 5/1 ARM could be a good choice for someone who expects a significant increase in income in the next five years.

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    7/1 ARM

    In a 7/1 ARM, the interest rate remains fixed for seven years before adjusting annually. This mortgage is ideal for those who plan to stay in their home for less than ten years.

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    10/1 ARM

    This mortgage has a fixed rate for the first ten years, followed by annual adjustments. A 10/1 ARM may be appropriate for someone who plans on staying in their home for around a decade.

Two other types of ARMs worth mentioning are:

  • Payment Options ARMs: These offer borrowers the flexibility to choose from several payment options each month, including a minimum payment, interest-only payment, 15-year or 30-year fixed payment. It's important to note that making minimum payments can result in negative amortization, where the loan balance increases instead of decreasing.
  • Interest-Only (I/O) ARMs: With this type, you only pay the interest for a specified period (typically 5 to 10 years), keeping your payments low. However, once the interest-only period ends, your payments can increase significantly since you start repaying the principal.

Remember that while an ARM's initial interest rate might be lower than that of a fixed-rate mortgage, the rate and monthly payments can increase over time. It's essential to consider your financial stability, risk tolerance and long-term plans before choosing an ARM.

Interest Rate Index and Margin

Regarding adjustable-rate mortgages, the terms "index" and "margin" play a vital role.

The index is generally a measure of interest rates, and the interest rate on your ARM is a function of the index rate. In other words, if the index rate moves up or down, so will your mortgage interest rate. For example, the index could be based on the U.S. Prime Rate, SOFR or various U.S. Treasury bill rates. Your lender will disclose the index chosen and where you can find its current value.

The margin, on the other hand, is a fixed number added to the index rate to determine your total interest rate. It doesn't change throughout the loan's duration. The margin reflects the lender's costs to do business. It can vary from one lender to another, so it's an essential factor to consider when comparing loan offers. The combined index rate and margin value equals the fully indexed rate for your ARM.

For instance, if the index rate is 2.5% and the lender's margin is 2%, the fully indexed interest rate you'll pay would be 4.5%.

Adjustment Periods and Caps

In an ARM, adjustment periods are the times when your interest rate will change. They're usually expressed in months or years. For example, a 5/1 ARM will adjust yearly after the first five. In contrast, a 3/3 ARM would adjust every three years after the initial three years. It's crucial to understand the adjustment periods, as they affect the frequency of changes in your monthly payment.

Rate caps significantly affect how much your payments can increase and are a form of consumer protection. These caps limit how much the interest rate can change at any single adjustment and over the life of the loan. There are three types:

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    Initial Adjustment Caps

    It limits how much interest rates can fluctuate during the first adjustment period after the fixed-rate period ends.

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    Periodic Adjustment Caps

    It limits how much the interest rate can change between adjustment periods after the initial one.

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    Lifetime Caps

    This cap restricts how much the interest rate can increase over the loan’s life.

These caps are significant because they protect you from drastic increases in your mortgage payment. Even if interest rates skyrocket, you'll have the reassurance that the caps will limit your rates from increasing. As with all mortgage terms, it's crucial to understand these and ask your lender to explain any terms you don't understand.

Pros and Cons of Adjustable-Rate Mortgages

Buying a home is one of the most significant financial commitments a person can make. Integral to this decision is the type of mortgage you choose. An adjustable-rate mortgage (ARM) is one such option. Understanding the pros and cons of an ARM is helpful because it can significantly impact your long-term financial health and home ownership experience.

Benefits of Adjustable-Rate Mortgages

Adjustable-rate mortgages have several potential benefits that can make them an attractive choice for certain borrowers. Let's explore some of them:

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    Lower Initial Interest Rates

    Compared to fixed-rate mortgages, ARMs often start with lower interest rates. This can make them particularly attractive to borrowers planning to sell or refinance their home before the rate begins to adjust.

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    Lower Monthly Payments During the Fixed-Rate Period

    Because the initial interest rate is lower with an ARM, the monthly payments are also lower during the initial fixed-rate period. This can offer a significant cost advantage, especially during the early years of the loan.

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    Opportunity To Take Advantage of Decreasing Interest Rates

    Unlike fixed-rate mortgages, ARMs provide the chance to benefit from a decrease in interest rates. If the rates go down, so too will your monthly payment, provided you're past the initial fixed-rate period.

Risks and Considerations

However, ARMs are not without their risks. Here are some factors to consider:

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    Potential Rate Increases

    After the fixed-rate period, your interest rate can increase. If the rates rise significantly, your monthly payment could become unaffordable, creating a financial burden.

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    Payment Shock

    This is a sudden, drastic uptick in your mortgage payment. It often happens when the interest rate increases significantly at the first adjustment.

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    Need to Budget for Possible Payment Fluctuations

    Budgeting for potential changes is critical because your interest rate and monthly payment can increase after the fixed-rate period. You need to ensure you can afford the mortgage payment if it rises to the maximum amount allowed under the loan terms. It's a good idea to plan for this ahead of time so that you're not caught off guard.

These considerations emphasize the need for potential borrowers to thoroughly assess their ability to afford an ARM, considering both the possible benefits and the inherent risks. Understanding these aspects before signing onto an adjustable-rate mortgage is essential.

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MONEYGEEK EXPERT TIP

An adjustable-rate mortgage is only risky if you don't take the financial responsibility seriously. An ARM isn't a "set it and forget it" mortgage like a fixed rate. ARM borrowers must be actively engaged in their mortgage, fully understanding how much they are saving, when their rate is adjusting and whether or not to pivot to a fixed rate. Bonus tip: Take the money your ARM is saving you initially and bank or invest those funds. — Timothy Manni, Mortgage and Real Estate Consultant

When Should You Use an Adjustable Rate Mortgage?

When considering an adjustable-rate mortgage (ARM), understanding how your circumstances align with these loan types' features is key. Your long-term plans, financial stability and risk tolerance can significantly influence whether an ARM fits your situation well.

Scenarios Favoring Adjustable Rate Mortgages

There are several situations where an adjustable-rate mortgage could be advantageous.

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    Short-Term Homeownership Plans

    An ARM may be advantageous if you plan on selling your home within a few years. The lower initial interest rates mean you can save on interest costs compared to a fixed-rate mortgage.

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    Confidence in Future Income Growth

    An ARM may be a good fit if you're in a profession where substantial income growth is common. An increased income can help you manage potential interest rate increases.

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    Taking Advantage of Low Initial Rates in a Declining Interest Rate Environment

    If interest rates are high but expected to drop, you could benefit from an ARM. When rates decrease, your interest rate and monthly payment will also lower.

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    Planning To Refinance or Sell the Property Before the Initial Fixed-Rate Period Ends

    If you plan on refinancing or selling before the fixed-rate period ends, you can take advantage of the lower initial interest rates without worrying about future hikes.

Scenarios When ARMs Might Not Be the Best Option

While ARMs can be beneficial in certain situations, there are scenarios where homebuyers may be better off with another financing option.

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    Long-Term Homeownership Plans

    A fixed-rate mortgage might be a better option if you plan on staying in your home for many years. The stability of a fixed rate can provide peace of mind and protection against potential rate increases.

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    Uncertain Financial Situations

    An ARM could be risky if your income is unstable or you're unsure about your ability to handle potential payment increases. A fixed-rate mortgage provides predictable and consistent monthly payments regardless of market fluctuations.

In any case, assessing your financial situation, plans and risk tolerance is crucial when deciding which type of mortgage to choose. As always, we recommend consulting with a financial advisor or mortgage professional to help guide your decision.

Frequently Asked Questions

Learning about adjustable-rate mortgages (ARMs) can leave you with many questions. Here are the commonly asked ones to help you navigate the complexities of ARMs.

Can the interest rate on an adjustable-rate mortgage increase indefinitely?
What happens to my adjustable-rate mortgage if the interest rate index drops significantly?
How do I determine if an adjustable-rate mortgage or a fixed-rate mortgage is better for me?
Can I refinance an adjustable-rate mortgage into a fixed-rate mortgage later on?
Are there any specific qualifications or requirements for obtaining an adjustable-rate mortgage?

About Christopher Boston


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Christopher (Croix) Boston was the Head of Loans content at MoneyGeek, with over five years of experience researching higher education, mortgage and personal loans.

Boston has a bachelor's degree from the Seattle Pacific University. They pride themselves in using their skills and experience to create quality content that helps people save and spend efficiently.