An adjustable-rate mortgage (ARM) is a type of home loan that comes with an initially fixed interest rate. This fixed rate is usually lower than what you’d get with a typical fixed-rate mortgage (FRM). Once the fixed-rate period ends, the interest rate becomes variable. This means it can rise or fall with the market, subject to other limitations in your loan agreement with the lender.
An adjustable-rate mortgage loan could be a good option if you’re trying to get the lowest interest rate possible and intend to sell your home before the fixed-rate period ends. However, these home loans come with some drawbacks and might not be right for everyone.
Find out how adjustable-rate loans work so you can make the right decision.
What is an adjustable-rate mortgage and how does it work?
Adjustable-rate mortgage loans, or variable-rate mortgages, are a type of home loan. Unlike fixed-rate mortgages, which have a set interest rate for the life of the loan, ARMs come with an adjustable and fixed-rate period.
During the fixed-rate period, your interest rate will stay the same. This period lasts a set amount of time — usually 1, 3, 5, 7, or 10 years.
Once the fixed-rate period ends, ARMs switch to a variable rate. This lasts for the remainder of the loan. At this point, the interest rate can increase or decrease based on the market. Depending on the type of ARM you get, the rate could fluctuate monthly or yearly. Your mortgage payments will also change based on your rate.
Home loans with an adjustable rate usually have two numbers (e.g., 5/1 or 10/6). The first number represents how long the interest rate will stay the same. The second number indicates how often the rate will change after the fixed-rate period ends. These numbers can represent either months or years, depending on the loan.
For example, a 5/1 ARM will have a set interest rate for five years. After that, the interest rate will change every year. If your loan has a 30-year repayment term, that means each of the final 25 years will have a variable interest rate.
How is the variable interest rate set?
An adjustable mortgage comes with an index and a margin. The index is a baseline interest rate based on current market conditions. The margin is based on the lender, loan type, and the consumer’s financial circumstances. Unlike the index, the margin does not change after closing.
Whenever it’s time to adjust the rate, such as when the initial fixed-rate period ends, your lender will add the margin and index together. The result is your new variable rate.
ARMs also have specific rate caps that help control how much the interest rate can change once the fixed period ends. This can prevent major rate increases, even if the market experiences significant changes.
There are three main types of rate caps:
- Lifetime adjustment rate cap: This sets a minimum and maximum limit on how much the interest rate can change over the life of the loan. The maximum is usually 5 percentage points higher than the initial rate.
- Initial adjustment rate cap: This limits how much the mortgage rate can rise once the initial fixed rate ends. The maximum increase is usually between 2% and 5%.
- Subsequent adjustment rate cap: This puts a cap on how much the rate can fluctuate within each adjustment period. It’s usually no more than 2 percentage points higher than the most recent interest rate.
What are the adjustable-rate mortgage term options?
Most adjustable-rate mortgages come with either 15- or 30-year terms. However, some lenders will offer custom repayment terms.
The term you choose directly impacts your monthly payment amount, your total interest charges, and how long you have to pay off your loan. A longer term usually means smaller monthly payments, but it might also mean more overall interest charges.
With ARMs, a longer term also means more total changes to your interest rate.
Say, for example, you have a 30-year 5/6m ARM. In this case, the “m” stands for month. So, once the first five years are over, your rate will change every six months. Over the next 25 years, your rate will change approximately 50 times.
What are the types of adjustable-rate mortgages?
Several common types of adjustable-rate mortgages exist, including:
- Hybrid ARMs: A hybrid ARM is a type of mortgage that has an initially fixed interest rate that fluctuates based on market conditions. Common options include 3/1 ARMs, 5/1 ARMs, 5/6 ARMs, 7/1 ARMs, and 7/6 ARMs. The first number indicates how many years the interest rate will remain the same. The second number indicates how often it will change after that.
- Interest-only ARMs: With this adjustable-rate loan, you’ll only pay interest on the loan for a set period of time. This means smaller monthly payments since you aren’t paying toward the principal. Once the interest-only period ends, you’ll need to start paying back the principal and interest.
- Payment Option ARMs: This type of ARM comes with several payment options. For example, you could pay both the principal and interest, or make interest-only payments. Or you could make minimum monthly payments, though these might not cover what you owe and could keep you in debt longer.
Adjustable-rate mortgages vs. fixed-rate mortgages
ARMs differ from fixed-rate mortgages in terms of the interest rate changes over time. Here’s an example of what an adjustable mortgage rate and a conventional loan might look like*:
(During fixed seven-year period) | (Throughout loan term) | |
(After initial seven years) | (Throughout loan term) | |
*This is a hypothetical example and is not intended to indicate a loan type that may be available through a lender participating on the Credible platform.
**Calculations do not include HOA dues, property taxes, or homeowners insurance.
Pros and cons of adjustable-rate mortgages
Getting an adjustable-rate mortgage comes with its share of advantages and drawbacks.
Here are the main advantages of an adjustable-rate mortgage:
- Lower initial interest rate: ARMs may have a starting interest rate that’s lower than fixed-rate mortgages. This could result in smaller monthly payments as well.
- Interest rate may decrease: After the fixed-rate period ends, the interest rate could decrease depending on current market conditions. This could mean lower monthly payments or lower overall interest charges. However, the rate cap will influence how much the rate can drop.
- Convenient for short-term ownership: With the lower initial interest rate, ARMs could be a more cost-effective option than FRMs. This makes them useful for homeowners who want to sell their homes before the fixed rate ends.
Here are the main disadvantages of an adjustable-rate mortgage:
- Fluctuating interest rates: Once the fixed rate period ends, the interest rate will become variable. It could change every few months or years. This could result in higher monthly payments and overall interest charges.
- Inconsistent monthly payments: Variable interest rates may make it harder to account for your monthly payments when budgeting.
- No guarantee of refinancing or selling early: Even if you plan to sell your home early or refinance it for a lower rate, you might not be able to.
- It could be financially risky: If your monthly payment is too high as your rate increases, you could struggle to make payments.
Adjustable-rate mortgage FAQ
What is the most common type of ARM?
Hybrid ARMs are among the most common types of ARMs. These loans usually come with an initial fixed rate for the first 3, 5, 7, or 10 years. They also typically have 15- or 30-year repayment terms.
What is an adjustable-rate mortgage cap?
An adjustable-rate mortgage cap is a limit on how much the interest rate can increase over the course of the loan. Rate caps are usually between 2 percentage points to 5 percentage points higher than the initial or previous interest rate.
When is an ARM a good idea?
An adjustable-rate mortgage might be a good idea if you plan to refinance or sell the home before the fixed-rate period ends. It might also be a good idea if you expect an income increase and are confident you can handle potentially higher monthly payments.
However, getting an ARM could be risky if the interest and monthly payments increase but you aren't financially prepared. Failure to keep up with payments could result in losing your home.
