Adjustable-Rate Mortgage ARM: What It Is and Different Types

If rates are up when your ARM adjusts, you’ll end up with a higher rate and a higher monthly payment, which could put a strain on your budget. If you’re in the market for a home loan, one option you might come across is an adjustable-rate mortgage. These mortgages come with fixed interest rates for an initial period, after which the rate moves up or down at regular intervals for the remainder of the loan’s term. Notably, some ARMs have payment caps that limit how much the monthly mortgage payment can increase in dollar terms. That can lead to a problem called negative amortization if your monthly payments aren’t sufficient to cover the interest rate that your lender is changing. With negative amortization, the amount that you owe can continue to increase even as you make the required monthly payments.

Payment uncertainty

After that initial period, the rate adjusts annually or according to the terms set by the lender, which might be more or less frequent. Since the rate on a fixed-rate mortgage doesn’t change, you won’t have to worry about your monthly payments changing. These adjustments are based on a market index—the Secured Overnight Financing Rate (SOFR) being the most common for adjustable-rate products—that your lender uses to set and follow rates. There are a few different indexes, and the benchmark index rate your lender chooses might be different from what another lender chooses.

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There are certain features that might entice you to choose an ARM over a fixed-rate mortgage. There are benefits and drawbacks to consider before deciding if an adjustable-rate mortgage (ARM) is right for you. Yes, you can refinance your ARM to a fixed-rate loan as long as you qualify for the new mortgage. There are several moving parts to an adjustable-rate mortgage, which make calculating what your ARM rate will be down the road a little tricky. The interest rate on ARMs is determined by a fluctuating benchmark rate that usually reflects the general state of the economy and an additional fixed margin charged by the lender. Opting to pay the minimum amount or just the interest might sound appealing.

What are today’s mortgage rates?

It also includes finding the right type of mortgage that’s best for your budget—loan term, interest rate and monthly payment all play a factor in what you can reasonably afford. An adjustable-rate mortgage (ARM) might be something to consider as you’re exploring different borrowing options. The monthly payments for shorter-term mortgages are higher so that the principal is repaid in a shorter time frame.

Advantages of adjustable-rate mortgages

See the table below for a detailed breakdown of how each loan type moved. We’re transparent about how we are able to bring quality content, competitive rates, and useful tools to you by explaining how we make money. Two key factors known as “index” and “margin” determine your ARM’s interest rate. When interest rates are falling, the interest rate on an ARM mortgage will decline without the need for you to refinance the mortgage. To make sure you can repay the loan, some ARM programs require that you qualify at the maximum possible interest rate based on the terms of your ARM loan. Another key characteristic of ARMs is whether they are conforming or nonconforming loans.

What is a mortgage rate lock?

An ARM doesn’t make sense if you’re buying or refinancing your “forever home” or if you can only afford the teaser rate.

What are ARM rate caps?

• With an ARM, the initial interest rate is fixed for a period of time.
• At the current average rate, you’ll pay $665.97 per month in principal and interest for every $100,000 you borrow.
• Ask each lender to explain what kind of interest rate cap structure it uses for its ARMs as you shop around.
• Yes, you can refinance your ARM to a fixed-rate loan as long as you qualify for the new mortgage.
• These options typically include payments covering principal and interest, paying down just the interest, or paying a minimum amount that does not even cover the interest.
• The traditional 30-year fixed-rate mortgage is the most common type of home loan, followed by the 15-year fixed-rate mortgage.

If you are considering an ARM, calculate the payments for different scenarios to ensure you can still afford them up to the maximum cap. For instance, if you take out a 5/1 ARM with an index at 3% and a margin of 2%, your intro rate is 5%. Let’s say when the intro period ends, the index has dropped to 1.5% — your rate for the following year will be 3.5% (1.5% index + 2% margin). We’re the Consumer Financial Protection Bureau (CFPB), a U.S. government agency that makes sure banks, lenders, and other financial companies treat you fairly.

Hybrid ARM

Our award-winning editors and reporters create honest and accurate content to help you make the right financial decisions. The interest rate and payment on an adjustable rate mortgage can increase substantially over time. This is risky because it could make your mortgage payments unaffordable, especially if you have an unexpected financial change in the future like a job loss. If you’re in the military and find yourself relocating every 4 to 5 years, for example, the lower initial rate and payments on an ARM could be a better option than a fixed-rate mortgage. An ARM can also be a great option for first-time homebuyers who plan to start a family and upsize to a bigger home within five to 10 years. With an ARM, your monthly payment may change frequently over the life of the loan, and you cannot predict whether they will rise or decline, or by how much.

Flexibility to Adjust with Market Trends

Shorter-term mortgages offer a lower interest rate, which allows for a larger amount of principal repaid with each mortgage payment. So, shorter term mortgages usually cost significantly less in interest. In a fixed-rate mortgage, the interest rate is set at the beginning of the loan and does not fluctuate with market conditions. This fixed rate is typically determined based on the borrower’s creditworthiness, the loan term, and prevailing market rates at the time of origination.

Definition of an adjustable-rate mortgage

But payments will balloon later on, and when this happens you will still have the full loan balance to pay off. Keep in mind that adjustable mortgage rate don’t always increase. If the index rate to which your loan is tied has fallen by the time your loan adjusts, your rate and payment also have to potential to go down. The initial period of an ARM where the interest rate remains the same typically ranges from one year to seven years. An ARM may make good financial sense if you only plan to live in your house for that amount of time or plan to pay off your mortgage early, before interest rates can rise. While there are rate caps in place to protect you, that doesn’t mean your rate and payment can’t increase significantly over time.

How Fixed Interest Rates Work

A fixed-rate mortgage, on the other hand, has one set interest rate that doesn’t change for the life of your loan. This type of mortgage can be a more affordable means to get into a home, especially when higher rates on fixed mortgages are beginning to price some borrowers out. But is it worth the risk of unknown and potentially larger payments in the future? Here’s how to know if you should get an adjustable-rate mortgage. If interest rates in general fall, then homeowners with fixed-rate mortgages can refinance, paying off their old loan with one at a new, lower rate. The ARM index is often a benchmark rate such as the prime rate, the LIBOR, the Secured Overnight Financing Rate (SOFR), or the rate on short-term U.S.

• Unlike ARMs, traditional or fixed-rate mortgages carry the same interest rate for the life of the loan, which might be 10, 20, 30, or more years.
• If you cannot afford your payments, you could lose your home to foreclosure.
• If you’re confident you’ll be moving before the fixed-rate period ends, an ARM could be a great choice.
• However, the deterioration of the thrift industry later that decade prompted authorities to reconsider their initial resistance and become more flexible.
• This allows you to pay lower monthly payments until you decide to sell again.
• If you’re in the military and find yourself relocating every 4 to 5 years, for example, the lower initial rate and payments on an ARM could be a better option than a fixed-rate mortgage.

• An adjustable-rate mortgage makes sense if you have time-sensitive goals that include selling your home or refinancing your mortgage before the initial rate period ends.
• The most obvious advantage is that a low rate, especially the intro or teaser rate, will save you money.
• An ARM can also be a great option for first-time homebuyers who plan to start a family and upsize to a bigger home within five to 10 years.
• It also includes finding the right type of mortgage that’s best for your budget—loan term, interest rate and monthly payment all play a factor in what you can reasonably afford.
• After the fixed-rate period expires, your rate will start to adjust depending on where the index is at the time.
• Use our interactive Loan Estimate to double-check that all the details about your loan are correct.
• The primary benefit of a fixed-rate mortgage is the stability it offers.

The most obvious advantage is that a low rate, especially the intro or teaser rate, will save you money. Not only will your monthly payment be lower than most traditional fixed-rate mortgages, but you may also be able to put more down toward your principal balance. Just ensure your lender doesn’t charge you a prepayment fee if you do. In most cases, you can choose the type of mortgage loan that best suits your needs.

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One drawback is that fixed-rate mortgages often have higher initial interest rates compared to adjustable-rate mortgages. Additionally, if market interest rates decline, homeowners with fixed-rate mortgages will not benefit from the lower rates unless they refinance their loans. Bankrate follows a strict editorial policy, so you can trust that we’re putting your interests first.

If the balance rises too much, your lender might recast the loan and require you to make much larger, and potentially unaffordable, payments. For example, a 2/28 ARM features a fixed rate for two years followed by a floating rate for the remaining 28 years. In comparison, a 5/1 ARM has a fixed rate for the first five years, followed by a variable rate that adjusts every year (as indicated by the number one after the slash). Likewise, a 5/5 ARM would start with a fixed rate for five years and then adjust every five years.

• ARMs have been around for several decades, with the option to take out a long-term house loan with fluctuating interest rates first becoming available to Americans in the early 1980s.
• While we strive to provide a wide range of offers, Bankrate does not include information about every financial or credit product or service.
• Thirty-year mortgage rates tend to track the 10-year Treasury yield, which shifts continuously alongside the economy and the forces that shape it.
• The monthly payments for shorter-term mortgages are higher so that the principal is repaid in a shorter time frame.
• Some ARMs have the potential to leave you in negative amortization, which means that even when you’re making payments, they’re not enough to cover the interest on your loan.
• When fixed-rate mortgage rates are high, lenders may start to recommend adjustable-rate mortgages (ARMs) as monthly-payment saving alternatives.

Occasionally the adjustment period is only six months, which means after the initial rate ends, your rate could change every six months. The best way to get an idea of how an ARM can adjust is to follow the life of an ARM. For this example, we assume you’ll take out a 5/1 ARM with 2/2/6 caps and a margin of 2%, and it’s tied to the Secured Overnight Financing Rate (SOFR) index, with an 5% initial rate. Borrowers have many options available to them when they want to finance the purchase of their home or another type of property. While the former provides you with some predictability, ARMs offer lower interest rates for a certain period before they begin to fluctuate with market conditions.

Adjustable-rate mortgage pros and cons

We continually strive to provide consumers with the expert advice and tools needed to succeed throughout life’s financial journey. When you’ve decided which type of mortgage is best for you, reach out to a lender to get started right away. With a payment option ARM, you have a few different ways to pay back your loan. You’ll have a fixed rate for the first decade, and then the rate changes once per year after that. Yes, if your ARM loan comes with a “conversion option.” Lenders may offer this choice with conditions and potentially an extra cost, allowing you to convert your ARM loan to a fixed-rate loan. You may need a score of 640 for a conventional ARM, compared to 620 for fixed-rate loans.

A fixed-rate mortgage comes with a fixed interest rate for the entirety of the loan. This means that you benefit from falling rates and also run the risk if rates increase. The term adjustable-rate mortgage (ARM) refers to a home loan with a variable interest rate. With an ARM, the initial interest rate is fixed for a period of time. After that, the interest rate applied on the outstanding balance resets periodically, at yearly or even monthly intervals.