What is an adjustable-rate mortgage?
An adjustable-rate mortgage (ARM) is a type of mortgage in which the interest rate on the loan varies with prevailing market rates. This means that, over time, the monthly payment amount may go up or down, depending on the current interest rates set by the Fed. ARMs are often used when interest rates are low, to provide more affordable monthly payments. However, they can also be risky if interest rates rise sharply.
An adjustable-rate mortgage may be a good choice for you if:
- You plan on being in your home for only a few years.
- You want to take advantage of a low initial interest rate.
- Your credit score is above the average.
- You can afford to make higher monthly payments if interest rates go up.
- You want a 30-year mortgage and a lower interest rate.
An ARM may not be a good idea over a fixed-rate mortgage (FRM) if:
- You think interest rates will go up in the future.
- You don’t want to deal with the hassle of refinancing every few years.
- You plan on living in your home for a long time, or are already retired and will not be moving soon.
- You don’t have enough income or stable income to qualify for a traditional mortgage.
When considering an adjustable-rate mortgage, it’s important to watch out for the following:
- The possibility that interest rates could rise significantly over the life of the loan, resulting in much higher monthly payments.
- The “margin,” or difference, between the initial interest rate and the maximum allowed interest rate. The smaller this margin, the less risky the ARM loan is.
- The “cap,” or maximum increase, in the interest rate over the life of the loan. A cap at two percentage points is good, while a five-point cap is not as desirable.
- Fees. Fees associated with an ARM can be higher than those for a fixed-rate mortgage.
- Rate Change. ARM rates can change every month, every six months, or once a year. This will be spelled out in your loan agreement.
- Terms. The terms of an ARM vary widely, depending on the lender and the borrower. For example, adjustable-rate mortgages can have a fixed period (the term during which your interest rate will not change) that spans anywhere from one month to ten years. After this period, the rate is subject to change every month or year—or whenever specified by your contract.
Adjustable-rate mortgage case study
Let’s say you take out a 30-year ARM on a $625K home with an initial interest rate of just under 4%. That seems like a great deal, especially since the interest rate can only go up by two percentage points over the life of the loan. However, if interest rates rise to 6% or more, your monthly payment for a $500K mortgage could jump from $2,387 to $2,998—an increase of almost 26%.
The bottom line
An adjustable-rate mortgage, or ARM, is a type of mortgage in which the interest rate changes periodically. This means that the monthly payment can also change over time. ARMs are often used when interest rates are low, to provide more affordable monthly payments. However, they can also be risky if interest rates rise sharply.
ARMs are becoming more and more popular these days because they offer borrowers a lower initial interest rate than what they would get with a traditional fixed-rate mortgage. There are different types of ARMs out there, so it’s important to understand all of the terms before you sign on the dotted line.
Be sure to watch out for the possibility that interest rates could rise significantly over the life of the loan, and make sure you can afford to make higher monthly payments if that happens.