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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 periodic rate adjustments. ARMs are different from fixed-rate mortgages, which keep the same interest rate for the life of the loan.
How does an adjustable-rate mortgage work?
With an adjustable-rate mortgage, your payments can increase or decrease with interest-rate changes, based on the terms of your individual loan and a benchmark rate index. In some cases, choosing an ARM over a fixed-rate mortgage could be a solid financial decision, potentially saving you thousands of dollars. Ask loan officers to explain ARM risks and exactly how much the payments could increase.
Some people believe fixed-rate mortgages are always the better choice. But ARMs can be an option for home buyers who know they'll have the loan for only a few years. Carefully weigh the pros and cons before applying.
Adjustable-rate mortgage pros
Low payments in the fixed-rate phase
A hybrid ARM offers potential savings in the initial, fixed-rate period. Common ARM terms are 3 years, 5 years, 7 years and 10 years. With a 5-year ARM, for example, your introductory interest rate is locked in for five years before it can change. That gives you five years of predictable, low payments.
An ARM can be a good idea if your life is likely to change in the next few years — for instance, if you plan to move or sell the house. You can enjoy the ARM’s fixed-rate period and sell before it ends and the less-predictable adjustable phase starts.
Rate and payment caps
ARMs have caps that limit how much the mortgage rate and your payment can increase. These include caps on how much the rate can change each time it adjusts and the total rate change over the loan’s lifetime.
Your payments could decrease
If interest rates fall and drive down the index against which your ARM is benchmarked, your monthly payment could drop.
Adjustable-rate mortgage cons
Your payments could increase
If interest rates rise, your payments will increase after the adjustable period begins; some borrowers might have trouble making the larger payments.
Things don’t always go as planned
ARMs require borrowers to plan for when the interest rate starts changing and monthly payments grow. Even with careful planning, though, you might be unable to sell or refinance when you want to. If you can’t make the payments after the fixed-rate phase of the loan, you could lose the home.
ARMs are complex
ARMs can have complicated rules, fees and structures. These complexities can pose risks for borrowers who don’t fully understand what they're getting into.
Is an ARM right for you?
Whether an ARM is a good choice depends on your goals and comfort level with unpredictability. If you sell the home or pay off the mortgage before the adjustable rate goes up, you'll save money.
But an ARM probably isn't the right option if you plan to settle in for many years and want the certainty of a constant mortgage rate and monthly payment. In that case, a fixed-rate mortgage is the way to go.