An adjustable rate mortgage (ARM) is a home loan with an interest rate that changes after a fixed amount of time—usually 5-7 years. Adjustable rate mortgages s typically offer lower interest rates and lower monthly payments than a fixed rate mortgage. After the allotted time passes, the rate may adjust and your monthly mortgage payments will adjust accordingly.
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If your top priority is a low monthly payment or you don't plan on staying in your home for more than 5-7 years, an adjustable rate mortgage (ARM) could be right for you. If flexibility is your top priority, this loan can be a viable alternative to a 15 or 30-year fixed rate mortgage.
Is an adjustable rate mortgage right for you?
An adjustable rate mortgage can give you low rates and extra security—important considerations when searching for your perfect home. The benefits of an adjustable rate mortgage include:
ARM rates can be lower than a 30-year fixed rate.
ARMs can feature lower monthly payments early on in the loan term, allowing you to maximize cash flow.
ARM rates do not change during the initial term (5, 7 and 10-year options available).
Adjustment rate caps offer extra protection.
ARMs may benefit first-time homebuyers and those looking to refinance. With the lower monthly payments of ARMs, you may be able to buy a larger home you wouldn’t be able to otherwise.
As the borrower, you take advantage of lower initial payments by leveraging the possibility that the mortgage interest rate could increase after the initial term. This means that your adjustable rate mortgage transfers part of your home loan’s interest rate risk from the lender to the borrower, giving you the lowest rate on the market.
An adjustable rate mortgage is also a great way to qualify for a higher loan amount, giving you the means to purchase a more expensive home. Many homebuyers will take out large mortgages to secure a 1-year ARM and later refinance to prevent a rate hike.
However, ARMs are not the ideal mortgage solution for everyone. The following are some particularities of adjustable rate mortgages that may be less than ideal, causing you to rethink a standard fixed mortgage rate. .
Over the life of a loan, rates and payments can rise rather dramatically over the life of the loan. Depending on rates, is not uncommon for an ARM to double over just a few short years.
ARMs are generally more complex to understand than a typical fixed rate. An adjustable rate mortgage affords lenders the flexibility to determine adjustment indexes, margins, caps and more.
Negative amortization loans, a certain type of adjustable rate mortgage, can cause borrowers to wind up owing more money than they did to begin with. The reason is that the payments are set so very low, that even the interest is not being completely paid off. All of this then, naturally, gets rolled over to the balance, which can be formidable when all is said and done.
So, what’s the better choice? An adjustable rate mortgage or a fixed rate mortgage? This is a determination you will, of course, have to make yourself. Each offers something different. Fixed-rate mortgages offer a permanent rate and a sense of security but at rates that can seem daunting. An adjustable rate mortgage costs less initially, which is appealing, but may ultimately lead to uncertainty.
These key differences will be a huge factor in your decision but there are other important questions to answer when deciding which loan is better for you:
1. What is the current interest rate environment?
A major determining factor may be the current interest rate environment. If rates are low, a fixed-rate mortgage makes the most sense – you’re in an ideal financial environment that you won’t want to jeopardize. However, if rates have become high, things change. With an adjustable rate mortgage, you have a lower initial rate to begin with and if (and when) rates eventually fall, you may well wind up with lower payments. In the meantime, you get to enjoy the benefits of owning your own home.
2. Do you plan on staying in the home long?
If not, an adjustable rate mortgage may be the right call. Your initial payment and rate will be low and, if you’re only planning to stay for a few years, you’ll avoid exposure to the huge rate adjustments that can be an ARMs downfall. Meanwhile, you can build up your savings for the more ideal home you may have your eye on.
3. When is the adjustment for the ARM made? How frequently does it adjust?
After an initial fixed period, odds are your adjustable rate mortgage will adjust fairly frequently. Usually, this is on the same date as the initial mortgage making it a yearly anniversary you can count on, but in some cases they adjust much more frequently – sometimes even every month. For some, this can be volatile and overwhelming making a fixed-rate mortgage more appealing.