While there are many types of mortgages, many borrowers choose a 30-year fixed-rate mortgage that provides fixed monthly payments for the life of the loan.
But another option is an adjustable-rate mortgage (ARM), which typically begins with an interest rate that is fixed for a period of time—usually three to 10 years—and then adjusts based on an index (a benchmark interest rate tied to the ARM), plus a fixed margin set by the lender.
There are times when it makes sense to look beyond the basic 30-year loan, but you should make sure that you understand every detail about the financing responsibilities you’re assuming—including how high your payments will rise. Otherwise, you might face surprise expenses you can’t easily cover.
Fixed-rate vs. adjustable-rate mortgage
Because the interest rate on a fixed-rate mortgage stays the same during the entire loan term, this type of product is ideal for home buyers who plan to stay put for a lengthy time or indefinitely.
Meanwhile, since ARMs typically offer a fixed rate for a certain time and then adjust periodically throughout the rest of the term, they are perfect for people who only anticipate staying in their home during the fixed-rate period.
How an ARM works
ARMs usually are defined first by the length of the fixed-rate term, and then by how often the rate can reset after the fixed-rate period ends. With a 5/1 ARM, for instance, your interest rate will remain the same for the first five years and then can adjust each year after that until your loan is paid in full.
The interest rate adjustment is based on the index the ARM is tied to. If the index falls, your interest rate will decline and vice-versa. While interest rates can increase or decrease based on the index, some ARMs offer both a ceiling and a floor for interest rates. While adjustments to the interest rate typically happen once a year after the initial fixed-rate period, some ARMs also adjust more frequently.
Types of ARMs
Hybrid and interest-only are the two main kinds of ARMS. Hybrid mortgages have a fixed-rate period, followed by an adjustable-rate period where the interest rate can increase or decrease. You’ll pay both the principal and interest during all of the periods. Some common hybrid ARMs include 3/1, 5/1, 7/1 and 10/1 (meaning they offer a fixed rate for three, five, seven and 10 years, respectively, with rate adjustments allowed once every year thereafter).
Other hybrid ARM options include a 5/5 ARM, which has an initial five-year fixed-rate period and then transitions to an adjustable-rate phase in which the interest rate adjusts once every five years. Interest-only ARMs require borrowers to pay only the accrued interest on their mortgage during an initial interest-only period. Initial payments are typically lower than they would be with other types of mortgages.
Note: If you’re only paying interest, you’re not paying down the overall amount borrowed (or the principal). So, payments following the interest-only period will be significantly higher to account for both the principal and interest. Like a hybrid ARM, interest-only ARMs often include a fixed-rate period.
Is an ARM right for you?
This type of loan can be ideal for homebuyers who plan to stay in a home for just a short period of time, as most ARMs allow for flexibility and lower payments during the initial fixed-rate period. If you think you will relocate after four or five years, for example, choosing a 5/1 hybrid ARM could be a wise financial decision and save you thousands of dollars over what you’d pay with a traditional fixed-rate mortgage.
If you don’t think you’ll be able to afford the higher payments when the rates adjust, then the fixed option might be a better choice because there is no surprise in the payment adjustment and the payment actually diminishes over time because of inflation.
ARM benefits
You can secure a lower interest rate, which might mean you can end up getting more house for your money. If you know you only will be in the home for a short time, this is a good bet. You also could pay off your mortgage quicker. Barring prepayment penalties, a lower interest rate may enable the borrower to pay more of the principal on the loan.
This can save hundreds, or even thousands of dollars, in interest. The market could work in your favor, too, which means your mortgage could adjust to a lower rate down the line. Finally, borrowers also can refinance their mortgage if they notice market conditions are favorable. Keep in mind, though, that mortgage rates currently are at all-time lows.
ARM drawbacks
After the introductory interest period ends, and if market conditions cause interest rates to rise, your monthly loan payments could increase. This boost in interest may make it more difficult for you to afford your mortgage payments. Because there will be fluctuations, ARMs mandate that borrowers plan for significant rate increases, which would boost your monthly mortgage payments.
Refinancing could be an option, but it’s difficult to predict what interest rates will be and if you can qualify for better rates. Some borrowers may face foreclosure if they can’t keep up with the inflated payments.
Bottom line: If you don’t understand an ARM’s fine print and complexities, you could be caught off guard when the initial rate ends and a higher interest rate kicks in; you also may face repayment penalties if you want to sell your property or refinance. It’s wise to negotiate these penalties with your lender before accepting this type of loan.
