Considering an Adjustable-Rate Mortgage? Here’s What You Should Know
Introduction
An adjustable-rate mortgage (ARM) can be an attractive option for homebuyers looking for lower initial interest rates. However, since the interest rate changes over time, it’s important to understand how ARMs work, their benefits and risks, and when it may be a good idea to refinance into a fixed-rate mortgage (FRM).
This guide will help you determine whether an ARM is right for you by explaining its structure, different types of ARMs, and key considerations before choosing one.
Key Concepts
1. How Do ARMs Work?
An adjustable-rate mortgage (ARM) has an interest rate that changes over time, meaning your monthly payments may increase or decrease.
This differs from a fixed-rate mortgage (FRM), which has an interest rate that remains the same throughout the loan term, ensuring stable monthly payments.
ARM Structure: Two Key Periods
🔹 Initial Period (Fixed-Rate Period)
- Your interest rate remains fixed for a set number of years (e.g., 3, 5, or 10 years).
- During this time, your payments will not change.
🔹 Adjustment Period
- After the initial period, your interest rate adjusts periodically based on market conditions.
- Adjustments typically happen once a year but can vary based on your loan terms.
- Your new rate is determined by a financial index plus a fixed margin set by the lender.
💡 Important Consideration: Since ARMs adjust based on market rates, your monthly payments can increase significantly over time.
Data Insights: Understanding ARM Rate Caps
Most ARMs have rate caps to limit how much your interest rate can increase or decrease. These caps protect borrowers from extreme rate hikes.
| Rate Cap Type | Purpose | Example (5/2/5 Cap) |
|---|---|---|
| Initial Cap | Limits the first rate increase after the initial period. | Max increase of 5% in year 6. |
| Periodic Cap | Limits how much the rate can change per adjustment period. | Max increase of 2% per year. |
| Lifetime Cap | Limits the total increase over the loan’s life. | Rate cannot increase by more than 5% overall. |
🔹 Example: If you start with a 4% interest rate on a 5/1 ARM (5 years fixed, adjusts annually after) with a 5/2/5 cap, the maximum rate increase could be:
- Year 6: 4% → 9% (if market rates are high)
- Year 7: 9% → 11% (but only by 2% due to the periodic cap)
- Lifetime Limit: Cannot exceed 9% total increase (4% + 5%).
📖 Use our adjustable-rate mortgage calculator to estimate future payments based on potential rate increases.
When Should You Consider an ARM?
An ARM might be a good option if:
✅ You plan to move or sell your home within the initial fixed period.
- If you sell the home before the adjustment period, you can take advantage of the lower initial rate without worrying about future increases.
✅ You expect interest rates to drop in the future.
- If rates are currently high, an ARM allows you to start with a lower rate and refinance later when rates decrease.
✅ You want lower initial monthly payments.
- ARMs typically have lower starting rates than fixed-rate mortgages, making homeownership more affordable upfront.
🚨 Caution: If you plan to stay in the home long-term, you may face unpredictable payment increases once the adjustment period begins.
📖 Explore: Fixed vs. Adjustable-Rate Mortgage Comparison
Common Misconceptions About ARMs
❌ “ARMs always lead to higher payments.”
✅ ARMs start with lower rates and may remain affordable if market rates stay low.
❌ “I can’t refinance an ARM.”
✅ You can refinance into a fixed-rate mortgage if rates rise or if you want payment stability.
❌ “All ARMs adjust the same way.”
✅ Different ARMs have varied adjustment periods and rate caps, so it’s crucial to compare terms.
Practical Applications: Refinancing an ARM to a Fixed-Rate Mortgage
Switching from an ARM to a fixed-rate mortgage can provide long-term payment stability. Consider refinancing if:
🔹 Your ARM is about to adjust, and you want to avoid higher payments.
🔹 Interest rates are low, and you want to lock in a fixed rate.
🔹 You plan to stay in the home for many years and prefer stable payments.
Key Considerations Before Refinancing
✅ Closing Costs: Refinancing involves fees similar to purchasing a home.
✅ Prepayment Penalties: Some ARMs charge fees if you refinance within the first 3-5 years.
✅ Break-Even Point: Calculate how long it will take to recover refinancing costs through lower monthly payments.
📖 Use our fixed vs. adjustable-rate mortgage calculator to determine if refinancing makes sense for you.
Next Steps
✅ Evaluate your financial goals to determine if an ARM aligns with your plans.
✅ Compare different ARMs to understand rate caps and adjustment periods.
✅ Plan for potential payment increases by estimating future rates.
✅ Consider refinancing options if interest rates drop or your ARM is set to adjust.
An ARM can be a valuable mortgage option if used strategically. By understanding how ARMs work and preparing for possible adjustments, you can make an informed decision that supports your long-term financial stability. 🏡💰
Considering an Adjustable-Rate Mortgage? Here’s What You Should Know
Adjustable-rate mortgages have benefits and drawbacks that you should carefully consider when choosing a home loan. Learn about how ARMs work, the different types of ARMs, when an ARM may be a good option, and when to think about refinancing to a fixed-rate mortgage.
How Do ARMs Work?
An adjustable-rate mortgage (ARM) is a loan with an interest rate that will change throughout the life of the mortgage. This means that, over time, your monthly payments may go up or down.
This is different from a fixed-rate mortgage (FRM), which has a fixed interest rate that is set when you take out the loan and does not change. With this type of loan, your monthly payments will not change.
ARMs have two distinct periods:
- Initial period: Also known as the fixed-rate period, during this time, the interest rate on your loan doesn’t change. The initial period can range from six months to 10 years. The most common ARM terms will have an initial period of 3, 5 or 10 years.
After the initial period, most ARMs adjust. Simply put, when your loan adjusts, your interest rate may change.
- Adjustment period: All ARMs have adjustment periods that determine when and how often the interest rate can change. Your adjusted rate will be based on your individual loan terms and the current market.
You need to make sure you are financially prepared for rate adjustments if you are considering an ARM.
What Are the Different Types of ARMs?
There are different types of ARMs that lenders offer. The name of these ARMs will indicate:
- The duration of the initial period.
- How often in a year your rate can adjust during the adjustment period.
Let’s look at an example: The most common adjustable-rate mortgage is a 5/1 ARM. This means you will have an initial period of five years (the “5”), during which the interest rate doesn’t change. After that time, you can expect your ARM to adjust once a year (the “1”).
Most ARMS will also typically offer a rate cap structure, which is meant to limit how much your rate can increase or decrease.
There are three different caps:
- Initial cap: Limits how much your rate can increase when your rate first adjusts.
- Periodic cap: Limits how much your rate can increase from one adjustment period to the next.
- Lifetime cap: Limits how much your rate can increase or decrease over the life of your loan.
Let’s say you have a 5/1 ARM with a 5/2/5 cap structure. This means on the sixth year — after your initial period expires — your rate can increase by a maximum of 5 percentage points (the first “5”) above the initial interest rate. Every year thereafter, your rate can adjust a maximum of 2 percentage points (the second number, “2”), but your interest rate can never increase more than 5 percentage points (the last number, “5”) over the life of the loan.
When shopping for an ARM, you should look for interest rate caps you can afford.
When Should You Consider an ARM?
Many homeowners choose an ARM to take advantage of the lower mortgage rates during the initial period. You may consider an adjustable-rate mortgage if:
- You plan on moving or selling your home within five years, or before the adjustment period of the loan.
- Interest rates are high when you buy your home.
If rates are low, it would make more sense to get a fixed-rate mortgage to lock in the low rate.
Keep in mind that, with an ARM, there is a level of uncertainty about how much your monthly payment will go up or down. Depending on the market, your rate could adjust upward and increase your monthly payments. It is important to be mindful of this because you are still responsible for making your monthly payments if your rate adjusts upward.
When Should You Consider Refinancing to a Fixed-Rate Mortgage?
Switching from an adjustable-rate mortgage to a fixed-rate mortgage is one of the most common reasons homeowners choose to refinance.
You may want to refinance your ARM into a FRM if:
- Your ARM is scheduled to adjust soon. This is especially important if you cannot afford a higher monthly mortgage payment.
- Mortgage rates are low. This will help you lock in a low rate and take advantage of the stability of a fixed-rate mortgage.
Alternatively, if you plan to move soon, it may make financial sense to stick with an ARM.
Before you make plans to refinance later, it’s important to take into account the costs of refinancing — which are similar to what you pay when you purchase a home — and any penalties you may face if you refinance too soon.
Some ARMs may require you to pay fees or penalties if you refinance or pay off the ARM early, usually during the initial period (the first three to five years) of the loan. Prepayment penalties can total several thousand dollars. It’s important to know about these potential extra fees before you take out an ARM.
When it comes to mortgages, you have options. To determine the right mortgage for your situation, lean on your lender or financial professional for guidance. Be sure you know the details of how and when this type of loan may change your monthly payments.
