What is an Adjustable-Rate Mortgage?

An adjustable-rate mortgage, or ARM, is a home loan that starts with a low fixed-interest teaser rate for three to 10 years, followed by rate adjustments that are made periodically. In this way, ARMs are different from fixed-rate mortgages, which keep the same interest rate for the life of the loan. In this article, I will provide a guide to how ARMs work, as well as both their pros and cons.

How Does an Adjustable-Rate Mortgage Work?

With an adjustable-rate mortgage, your payments will increase or decrease with interest-rate changes, based on the terms of your individual loan and a benchmark interest rate index chosen by your lender. And in some cases, choosing an ARM over a fixed-rate mortgage could be a solid financial decision, potentially saving you thousands of dollars. Especially with the Fed having cut its rate to near zero in response to the Covid-19 pandemic, thus creating a climate for very low interest rates and subsequently very low mortgage rates, ARMs have become particularly attractive.

The Pros of an ARM

• Low payments in the fixed-rate phase: An ARM offers potential savings in the initial, fixed-rate period. Common ARM terms are 3/1, 5/1, 7/1 and 10/1. For example, with a 5/1 ARM, your introductory interest rate is fixed for five (5) years and can be adjusted every (1) year after that.

• Flexibility: An ARM can be a good idea if you plan to move or sell your home in the near future. You could enjoy the ARM’s fixed-rate period and sell before it ends and the less-predictable adjustable phase starts.

• Caps on your rate and your payment: ARMs may have several types of caps, which limit the increases on your mortgage rate as well as the size of your payment. These include caps on how much the rate can change each time it adjusts and the total rate change over the loan’s lifetime.
• Potential cost saver: If interest rates fall, which is currently the case in this Covid-19 environment, this leads to the index against which your ARM is benchmarked being driven down, which could lead to a drop in your monthly payment.

The Cons of an ARM

• Potential for increased costs: If interest rates are rising, your payments could increase after the adjustable period begins, meaning that you might have trouble making the larger payments.
• Uncertainty: Things do not always go as planned and ARMs require borrowers to plan for when the interest rate starts changing and monthly payments may grow. Even with careful planning, though, you might be unable to sell or refinance when you want to. In the case where you can’t make the payments after the fixed-rate phase of the loan, you could lose the home.
• Prepayment penalty: It is important to note that some ARMs come with a prepayment penalty, which is a fee that can be charged if you sell or refinance the loan. So if you plan on selling the home or refinancing within the first five years of the mortgage, you should choose a lender who offers a loan without this penalty.
• Added complexity: ARMs are much more complex than fixed-rate mortgages. They can have complicated rules, fees and structures, which can pose risks for borrowers who don’t fully understand what they're getting into. Hopefully this guide has provided you with the requisite information to make the best decision for you and your financial situation.

Conclusion

An adjustable-rate mortgage (ARM) is a type of mortgage in which the interest rate applied on the outstanding balance varies throughout the life of the loan. With an ARM, the initial interest rate is fixed for a period of time, and after, the interest rate resets periodically, at yearly or even monthly intervals. Importantly, there are limits set on how much the interest rates and payments can rise per year or over the lifetime of the loan. An ARM can be a smart financial choice for home buyers that are planning to pay off the loan in full within a specific amount of time or those who are confident that they are well positioned for a potential change in the rate. However, with all financial decisions of this magnitude, there is a sizable amount of risk. As always, make sure to consult all the information at your disposal when considering an ARM or a more traditional fixed-rate mortgage.