If you’re confident you’ll relocate or pay off your mortgage in 10 years or less, an adjustable-rate mortgage, or ARM, may be the best home loan option for you.
There are big differences between an ARM and its counterpart, the fixed-rate mortgage, so make sure you’re solid on the details before you choose. Picking the right loan for your situation — now and in the future — will help you save money and stress less.
Adjustable-rate mortgage definition
An adjustable rate mortgage is a home loan with an interest rate that can change over time. In most cases, an adjustable rate mortgage will have a low fixed-interest rate during the introductory period, which could be as few as three years or as many as 10.
“With an adjustable-rate mortgage, the interest rate and monthly payment may go up or down.”
When the introductory period expires, the interest rate adjusts to current market rates. If current rates are lower, your rate and mortgage payment may decrease. But if current rates are higher than the initial rate, your rate and mortgage payment may increase. ARM rates continue to change periodically — usually once a year — until you sell, refinance, or pay back the mortgage in full.
Types of adjustable-rate mortgages
There are many types of ARMs, but they all share the variable-rate characteristic. Some common types are:
Hybrid ARMs. These mortgages have two phases: a fixed-rate period — typically three, five, seven or 10 years — followed by an adjustable phase, during which your interest rate can move up or down, depending on an index of market rates chosen by your lender. How often the rate adjusts and other details about how your ARM works are written in the mortgage contract. Some possible hybrid ARMs:
3/1 ARM. The interest rate is fixed for three years, and then adjusts annually.
5/1 ARM. The interest rate is fixed for five years, and then adjusts annually.
7/1 ARM. The interest rate is fixed for seven years, and then adjusts annually.
10/1 ARM. The interest rate is fixed for 10 years, and then adjusts annually.
Interest-only ARM. An interest-only, or IO, ARM gives you a specified number of years, typically between three and 10, during which you pay only interest on your mortgage. Your payments stay low during the fixed-rate IO period. But paying only interest doesn’t reduce the loan amount. When the IO period ends your payments will be bigger, possibly much bigger, because they’ll include both principal and interest.
Payment-option ARM. These ARMs, which have become rare since the 2008 housing crisis, allow borrowers to choose one of several monthly payment options: an interest-only payment, a minimum payment that does not pay all the interest due, or a fully amortizing payment that includes principal and interest. These loans are extremely complicated and pose high risks to just about anyone on a budget.
» MORE: Compare a 5/1 ARM to a 10/1 ARM
Importance of ARM caps
Adjustable-rate mortgages can have several types of ARM caps, which place limits on when and how drastically your interest rate can change. Knowing the ARM cap for your mortgage can help you avoid financial surprises when your rate adjusts.
It’s important to compare ARM caps when shopping for an adjustable-rate mortgage lender, because they have a big impact on your monthly mortgage payment, as well as the total cost of the loan. Lenders with identical introductory rates may have different ARM caps.
“ARM caps limit when and how drastically your interest rate can change.”
Initial cap: This ARM cap dictates how much your interest rate can change during the first adjustment after your fixed rate expires. Initial adjustment caps are typically 2 or 5 percentage points.
Subsequent cap: Also known as the periodic or annual cap, this ARM cap controls how much your interest can change upon the second adjustment and all annual adjustments that follow. Subsequent ARM caps are typically set at 2 percentage points.
Lifetime cap: These ARM caps limit the total interest rate increase for as long as you have the loan. Lifetime adjustment caps are commonly set at 5 percentage points, but may be higher.
Payment cap: This cap indicates the total increase allowed on an ARM payment. While it may seem beneficial at first glance, an ARM payment cap could actually prevent your mortgage payment from fully covering future interest increases. This results in negative amortization, which means your loan balance would go up instead of down with each payment. Payment caps are rare and should always be approached with caution.
Other important adjustable-rate mortgage terms
ARMs come with complicated terms and conditions. Understanding them will help you know how the loan works and how your payment may change. Here are some of the terms you’ll hear:
Adjustment frequency: How often your interest rate will adjust after the introductory period.
Benchmark index: The interest rate index to which payment changes on an ARM are tied.
Introductory or teaser rate: The initial interest rate of your ARM, which does not change during the fixed-rate period of the loan.
When an adjustable-rate mortgage is a good idea
Here are some situations in which an ARM makes sense. Do any of them sound like yours?
You’ll own the house for only a short period of time. If you might relocate in 3, 5, 7, or 10 years, an ARM mortgage may save you money. Military families or doctors currently in a residency program are two examples where this might be the case.
You plan to pay off the total balance of the mortgage quickly. Do you expect a financial windfall, such as an inheritance or lawsuit settlement, in the next few years? An ARM mortgage may allow you to make smaller monthly mortgage payments until you can own the home free and clear.
You expect fixed-rate mortgage rates to decrease. It’s risky and hard to predict, but if you expect fixed-rate mortgage rates to drop below current ARM rates before your introductory period expires, an adjustable-rate mortgage may yield savings until fixed rates drop. Be aware that this option requires you to eventually refinance to a fixed-rate mortgage, which means choosing a lender, getting approved and paying closing costs, just like with your ARM mortgage.
When an adjustable-rate mortgage is a bad idea
An ARM probably isn’t the right choice if:
You plan to put down roots. If you’re buying your forever home, and have no plans to move away, a fixed-rate mortgage might be the more appropriate choice. While it may have a slightly higher rate, a fixed-rate mortgage involves less risk than an adjustable-rate mortgage, so your investment is better protected.
You want a predictable mortgage payment. Sure, the interest rate on a fixed-rate mortgage may initially be higher than an ARM, but you’ll never have to worry about it going up, and you’re always free to refinance your mortgage if rates drop significantly in the years ahead.
Your budget can’t handle a larger mortgage payment. Maybe you’re thinking about going back to school, starting a family or launching a business. These life changes could affect your income in the years ahead. If you’re not 100% sure you could handle a mortgage payment that gets bigger when rates adjust higher, stick with the predictability of a fixed-rate mortgage.