By definition, an adjustable-rate mortgage — aka ARM — is a home loan where your interest rate can change periodically over the life of the loan. Typically, ARMs start off with a lower rate compared to fixed-rate mortgages. So, getting an ARM can allow borrowers to pay less interest at first.
How Does an ARM Work?
Adjustable-rate mortgages can be less expensive in the short term because they initially come with lower interest rates compared to fixed-rate mortgages. This initial period usually lasts three, five, seven, or 10 years. Once it’s over, the interest rate on the ARM will adjust on a regular basis.
You can tell how the fixed and adjustment periods will work by looking at the structure of the ARM. For example, with a 5/1 ARM, the initial rate will be fixed for five years, and then adjust once per year after that based on the market. Each time the rate adjusts, you’ll get a new mortgage rate and monthly payment amount.
With an ARM loan, you need to be prepared for significant increases to your monthly payment. The principal and interest portions of the payment can go up drastically — sometimes even double the original amount. There may be limits to how high (and low) your interest rate and monthly payment can go, so make sure to understand how your ARM adjusts before signing up.
How your interest rate adjusts
Part of the interest rate on your ARM is linked to a broader measure of interest rates known as an index, which reflects how the economy is doing. When this index increases, the rate on your ARM will go up as well, and your monthly payment will become more expensive. Conversely, when the index decreases, your interest rate could go down — but that isn’t always the case. (It depends on the ARM.)
The remaining part of your interest rate is known as the margin, which is the number of extra percentage points that your lender adds to the index. This margin is set in stone when you take out the mortgage and won’t change, unlike the index.
Putting the index and the margin together results in the interest rate on your ARM.
Types of ARMs
There are three main types of adjustable-rate mortgages: hybrid ARMs, interest-only ARMs, and payment-option ARMs.
We covered this type of ARM above. Hybrid ARMs feature an initial period with a fixed interest rate, followed by an adjustment period where the rate will change on a regular basis.
This type of ARM starts off with an interest-only period where you pay only interest for a set number of years. Once that period ends, you need to begin repaying the principal as well — which means your monthly payment will increase, even if interest rates don’t change. The longer the interest-only period lasts, the higher your monthly payment will be afterward.
A payment-option ARM allows you to choose how you structure your monthly mortgage payment. These are the three options:
- A traditional payment covering both principal and interest.
- An interest-only payment.
- A minimum or limited payment.
Selecting the last option — a minimum payment — can mean that you won’t be paying enough to cover the amount of interest due, causing your loan balance to increase. You’ll want to avoid this scenario, because you could end up owing more than you did at the start of your mortgage.
Pros and Cons of an ARM
Adjustable-rate mortgages come with certain advantages, including:
- A lower interest rate to start. In general, the initial rate on an ARM is lower than the interest rate on a comparable fixed-rate mortgage. This means ARMs can be cheaper in the short term.
- Your monthly payment could decrease. If market conditions result in interest rates dropping, then the rate — and monthly payment — on your ARM may be reduced as well.
However, you should also be aware of the downsides of ARMs, such as:
- More uncertainty. After the initial fixed period, you won’t know what your interest rate will be. It’s harder to budget accurately in this situation, because your monthly mortgage payment will likely fluctuate.
- Your monthly payment could increase. If your interest rate adjusts upward, then you may end up on the hook for a significantly higher payment each month.
- Higher risk. In the worst-case scenario, your mortgage may become unaffordable if you aren’t prepared for the extremes that your interest rate and monthly payment could go to.
When Would It Be Better To Choose an ARM?
An adjustable-rate mortgage could be the right fit if you’re seeking a lower interest rate and sure that you won’t be stretched financially by potential increases to your monthly payment. Choosing an ARM also can be a good strategy if you’re planning to move soon. This allows you to take advantage of the lower initial interest rate and sell your home before the rate adjusts.
Adjustable-Rate Mortgage FAQ
Here are the answers to some frequently asked questions about adjustable-rate mortgages.