An Adjustable-Rate Mortgage, or ARM as it is commonly called, is a home loan with an initial interest rate lower than most fixed-rate loans. The tradeoff is that after the fixed-rate period ends, the interest rate can change annually thereafter, usually in correlation to an index.1 This fluctuation means your monthly payments can go up or down throughout the life of the loan.
For example, the 5/1 ARM is the most common adjustable-rate mortgage. It offers a lower or introductory rate that lasts for five (5) years. After the initial five-year period, the interest rate can change once a year, every year, for the remainder of the loan term.
Fixed- vs. Adjustable-Rate Mortgage Snapshot
|
|
Adjustable-Rate |
Fixed-Rate |
|
Features |
|
|
|
Pros |
|
|
|
Cons |
|
|
* After the ARM’s initial rate period, the rate can increase up to but not exceed the maximum rate, or CAP, listed in your loan agreement.
Is an ARM Right for You?
If you can relate to one of the following examples, an adjustable-rate mortgage may be in your future.
The Income-Earner Bump
A fixed-rate mortgage is better suited if the property will be your permanent residence, primary vacation home, or long-term investment option and if you have a consistent (i.e., frequency and amount) income that can support the predetermined payment amount for the life of the loan.
Conversely, the fixed-rate period of an ARM is typically one to 10 years so if you anticipate a bump in pay along the way, going with an ARM could save you from paying a lot of interest over the long haul.
The Short-Term Homeowner
An ARM may be an excellent choice if you don’t plan to live in the property long enough for the rates to rise. As mentioned earlier, the fixed-rate period of an ARM varies, typically from one year to 10 years, which is why an ARM might not make sense for people who plan to keep their home for more than that. However, if you know you are going to move within a short period, or you don’t plan to hold on to the house for decades to come, then an ARM might make a lot of sense.
The Pay-It-Off Type
An adjustable-rate mortgage is very attractive to borrowers with the cash to pay off the loan before the new interest rate kicks in. Although few may fall in this category, there are situations in which it may be possible to pull it off.
For example, a borrower who is buying one house and selling another one at the same time. That person may be forced to purchase the new home while the old one is in contract and, as a result, will take out a one- or two-year ARM. Once the borrower has the proceeds from the sale, they can turn around to pay off the ARM with the proceeds from the home sale.
You can afford to make enough accelerated payments to pay it off before it resets. Employing this strategy can be risky because life is unpredictable. While you may be able to afford to make accelerated payments now, if you get sick or lose your job, that may no longer be an option.
Choosing the Right One
While there are various factors that you need to consider, ask yourself the following questions:
- How long do you plan on staying in the home?
- What’s the current interest rate environment like?
- How frequently will the ARM adjust and when does the adjustment typically occur?
- If interest rates were to significantly increase, could you afford your “new” monthly payment?
You should weigh the advantage of a lower payment at the beginning of the loan against the risk of interest rate increases that would lead to higher monthly payments in the future. It is a trade-off. You get a lower rate with an ARM in exchange for assuming more risk. For many people, an ARM is the right mortgage choice, particularly if you don't plan on being in the home for more than 3 to 5 years.
Start Your Home Story Today
- Check out our daily rates and lock in a low rate at any time at no cost.2
- Apply with our easy online application to get pre-approved for free.
- Contact one of our mortgage experts to apply.
Find a Home and Be Rewarded
If you haven't found your dream home just yet, check out our Home Rewards Program.3 Get matched with the right realtor and earn a commission rebate when you buy or sell your home!
Equal Housing Opportunity | NMLS #407686