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What is an Adjustable-rate Mortgage?

Nicki & Karen » January 23, 2023

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adjustable rate mortgage

If you’re in the market for a new home, there’s a good chance that you’ll need to apply for a loan with a bank or other financial institution. In the event that this is the first home you’re buying, you’ll discover that there are many different types of mortgage loans you can apply for, one of which is an adjustable-rate mortgage (ARM). If you select this type of loan, you’ll receive a variable interest rate.

While the interest rate for this loan type is fixed for a set period of time, it will eventually vary based on market conditions. Even though the interest rates can increase significantly following the initial fixed term, most of these loans come with limits on how high the increase can be in a year or throughout the lifetime of your loan.

Adjustable-rate mortgages are commonly selected by potential buyers because of the low interest rate that will be affixed to the loan for a period of 5-10 years. If you believe that you can afford any rate increase that occurs, an ARM can help you save a considerable sum of money in the first years after you become a homeowner. In this guide, you’ll learn about adjustable-rate mortgages and when to consider them.

mortgages

Defining Adjustable-rate Mortgages

Adjustable-rate mortgages are home loans that come with interest rates that adjust over the course of the loan. Your interest rate will usually change according to market conditions. If the Federal Reserve increases nationwide rates, you’ll likely notice an increase in your rates shortly afterwards. However, this also means that your interest rate could eventually decrease, which isn’t possible with a fixed-rate loan.

Since ARMs are riskier for the borrower, they usually come with lower interest rates when compared to fixed-rate mortgages. Keep in mind, however, that the low initial interest rate won’t be around forever. Following the initial period, the monthly mortgage payment you’re expected to make can fluctuate on a regular basis, which makes it challenging to factor the payment into your budget.

Fixed Vs. Adjustable-rate Mortgages

There are two basic types of mortgages you can apply for, which include fixed-rate mortgages and adjustable-rate mortgages.

fixed vs adjustable rate mortgages

Fixed-rate Mortgages

A fixed-rate mortgages provides you with more predictability when it comes to your loan’s interest rate and your monthly mortgage payments. Your mortgage payment should remain the same throughout the entire loan term.

Adjustable-rate Mortgages

An adjustable-rate mortgage allows you to pay less interest throughout the initial period, which means that your monthly payments will be relatively low when you first purchase a home.

How Does an Adjustable-rate Mortgage Work?

An ARM is a long-term loan that includes a fixed period and an adjustable period. The fixed-rate period usually lasts for 5-10 years, which means that your interest rate won’t vary during this time. During the adjustment period, your interest rate changes on a monthly or annual basis. If you have a 30-year ARM that comes with a 10-year fixed period, you would be required to pay different rates for 20 years.

Conforming vs. Nonconforming ARM Loans

When you’re searching for an ARM loan to apply for, you’ll have the opportunity to select a conforming or nonconforming loan. A conforming loan is a type of mortgage that adheres to special guidelines that allow these loans to be sold to Freddie Mac or Fannie Mae. Lenders are able to sell mortgages that they create to government-sponsored entities that can repackage the loan on a secondary mortgage market.

In the event that a loan doesn’t adhere to the conforming guidelines, it becomes a nonconforming loan. While a nonconforming loan can help you purchase a home, many lenders that sell these loans aren’t reputable, which means that you’re risking your hard-earned money by applying for a nonconforming loan. If you select a nonconforming ARM, make sure that you read all of the fine print that details when rate resets occur.

ARM Rates and Rate Caps

Mortgage rates can vary based on numerous factors, which include everything from the current economic conditions to your credit score. As mentioned previously, the initial rate you’re given for an ARM will likely be lower than what you end up paying when the adjustable period kicks in.

The national interest rate can be used as a benchmark when determining what your interest rate will be. If you have a high credit score and are selecting a 30-year mortgage, your interest rate on an ARM will likely be close to the standard margin. Riskier borrowers will have higher interest rates. While your interest rate can increase, the rate caps that are in place indicate that the rate can’t increase too much within a short period of time.

Refinancing an ARM

ARM loans can be useful for specific situations. For instance, you can choose to refinance your ARM loan into a fixed-rate mortgage once the initial low-interest period comes to an end. When you refinance an ARM, you’ll be taking out an entirely new loan, which is used to pay off the initial mortgage. You’ll then be tasked with paying off your new mortgage at a fixed rate.

Even if you’re applying for a refinance mortgage with the same lender, you’ll likely need to go through the same steps that occurred when you first applied. For instance, bank statements and pay stubs should be provided.

Different Types of ARMs

There are several different types of ARMs, the primary of which include a hybrid loan, an interest-only (IO) loan, and payment option.

different types of arms

Hybrid ARMs

A hybrid ARM gives you a mixture of a fixed-rate period and an adjustable-rate period. When you select this loan, your interest rate will remain fixed for a short period of time before it begins to change on a regular basis. This is the most common type of adjustable-rate mortgage.

You’ll notice that a hybrid ARM comes with two numbers, which can be written as 2/28. The first number indicates the amount of time that the interest rate will be fixed. The second number refers to the amount of time that you’ll need to pay a variable rate. If you have a 5/1 ARM, this means that you’ll pay a fixed rate for five years before paying a variable rate that changes each year.

Interest-only (I-O) ARMs

An interest-only ARM allows you to pay interest for around 3-10 years, after which you’ll pay the loan’s interest and principal. By paying off a considerable amount of the interest early on, your loan payments will be small. Keep in mind, however, that a lengthy I-O period means that your payments will be high towards the end of the loan term.

Payment-option ARMs

A payment-option ARM has several different payment options to select from. For instance, you can pay for interest only, provide payments that cover interest and principal, or pay a minimal amount that doesn’t cover the interest you owe. While you might want to pay the minimum amount, you’ll still need to repay everything you owe by the loan’s end date.

Pros and Cons of ARMs

There are several advantages and disadvantages associated with adjustable-rate mortgages, all of which are listed below.

pros and cons of arms

Pros of ARMs

The main advantage of an ARM is that you’ll have a low interest rate early on. When your interest rate is low, you can put more towards your principal balance. The primary benefits that come with an adjustable-rate mortgage include:

  • You won’t need to refinance
  • You’ll save money on a short-term basis
  • Best used with short-term borrowing
  • Allows you to focus on other financial goals

Cons of ARMs

The main problem with an adjustable-rate mortgage is that your interest rate will eventually change, which makes it almost impossible to predict what your monthly mortgage payments will be. The primary issues that occur when you invest in an adjustable-rate mortgage include:

  • Your payments might increase if national rate hikes occur
  • These loans can be difficult to understand
  • Less predictable than fixed-rate mortgages

How the Variable Rate on ARMs Is Determined

Once you’ve reached the conclusion of the fixed-rate period, your interest rates can be adjusted based on a reference interest rate as well as a specific amount of interest higher than the index rate. While index rates can change, the margin will always remain the same. Let’s say that the index is currently 5% with a margin of 2%. Your loan’s interest rate will change to 7%. If the index changes to 2% following the next interest rate adjustment, your rate will drop to 4% because of the 2% margin.

Why Might an Adjustable-rate Mortgage be a Bad Idea?

Many new homeowners find adjustable-rate mortgages appealing because of their low interest rates and more flexible terms. However, these mortgages might not be favorable for you. Since your payments can vary substantially, it’s difficult to create a monthly or annual budget.

In the event that interest rates increase significantly in a short period of time, you may be in a position where you’re no longer able to repay the loan. Before you apply for a mortgage loan, weigh the pros and cons of fixed-rate and adjustable-rate mortgages. Think about which solution best suits your unique situation.

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