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What is an Adjustable-Rate Mortgage?

by Jackie Boies on
10/19/2022
in Housing and Homeownership
Signing mortgage documents.

A mortgage is a type of loan you take out to purchase a piece of property such as a primary home, a second home, rental, condo, or apartment. It’s an agreement between you and a bank or credit union—or another lender—that stipulates the terms for payments. The lender has the right to reclaim the property if you fail to make the payments as agreed, and the property serves as collateral to secure the loan.

The most popular type of mortgage is a fixed rate mortgage. As the name suggests, it locks you into a set interest rate for the life of the loan (usually 30 years), unless you later decide to refinance.

That stability is why fixed rate mortgages are so popular, but they’re not your only option. Depending on your circumstances (and your appetite for risk) you may want to finance your home purchase with an adjustable-rate mortgage (ARM).

How an Adjustable-Rate Mortgage Differs from Other Mortgages

The defining characteristic of adjustable-rate mortgages is their variable interest rates, which are usually tied to market conditions. During the first few years of the mortgage, the rate is fixed, just like a fixed rate mortgage.

Once the fixed period ends, however, the interest rate on your loan begins adjusting regularly, sometimes as frequently as every six months. These adjustments could be good or bad for your monthly payment, depending on how the corresponding market moves, but typically you should expect your rates to increase substantially. This means that an ARM can be much riskier than a fixed-rate mortgage if you don’t plan to sell or refinance before the terms change.

What to Know About ARM Terms

Usually, the initial fixed period for an ARM is 3, 5, or 7 years (sometimes even 10). The shorter the fixed period, the lower the interest rate, which means that – at least initially – you can often find a lower rate with an ARM as compared to a fixed rate mortgage. According to Bankrate, the average annual percentage rate (APR) on a 30-year fixed rate is up to 6.28% (as of Sept. 16, 2022) while the average APR on a 5-year ARM is 4.67%.

ARMs are more complicated than fixed-rate mortgages due to how often the interest rate—and your payment—changes. You have several things to track and understand about the terms, including the following:

  • Adjustment frequency: Amount of time between interest-rate adjustments.
  • Adjustment indexes: The interest rate changes for your ARM will be tied to the interest rate on a type of asset, like a certificate of deposit, or a benchmark interest rate like the Secured Overnight Financing Rate (SOFR).
  • Margin: The difference between your rate and the adjustment index. You will always pay a certain percentage over the identified adjustment index (possibly 2%, for example), which is the margin for your loan.
  • Caps: A cap sets a limit on the amount the interest rate can increase during each adjustment period.
  • Ceiling: The highest that the adjustable interest rate can go during the life of the loan.

Benefits of an Adjustable-Rate Mortgage

Lower interest rate. The biggest benefit of an ARM is that it typically comes with a lower interest rate (APR) and more affordable payment for the first few years.

Higher loan limit. Because of the lower APR, you may also be able to qualify for a larger loan with an ARM.

The Drawbacks of an Adjustable-Rate Mortgage

ARMs have big downsides, however, particularly if you plan to own the property beyond the life of the ARM’s fixed-rate period. Here’s what the Consumer Financial Protection Bureau recommends you understand:

  • Your monthly payments could go up — sometimes by a lot—even if interest rates don’t go up.
  • Your payments may not go down much, or at all—even if interest rates go down.
  • You might end up owing more money than you borrowed—even if you make all your payments on time.
  • If you want to pay off your ARM early to avoid higher payments, you might pay a penalty.

Another downside to watch out for is a negatively amortizing loan. It’s a type of ARM that offers a monthly payment so low that each payment might not cover all of your monthly interest. The unpaid interest then gets shifted to your principal balance and increases the loan balance. That could mean that after a certain number of years of payments, your remaining principal may actually total more than what you borrowed.

When Should You Use an Adjustable-Rate Mortgage?

ARMS are best suited for the following types of borrowers:

Someone expecting an income boost

 For example, if you’re a couple years away from finishing your medical residency and you expect a significant income boost, then maybe an ARM could work with an all-but-certain pay raise on the horizon.

You don’t plan to have the home (or the loan) for very long

Are you expecting to move in a few years? Do you plan to buy a new home before you’ve sold the old one or refinance in the near future? If you don’t anticipate maintaining the ARM past the point when the APR goes up, this might work out well for you. Just be aware of any early payoff penalties.

The most important thing to understand is that if you’re using an ARM because you can’t afford a home otherwise, you could be setting yourself up for financial difficulty in a few years. For most people, a fixed-rate mortgage is a safer way to purchase a home.

How to Apply for an ARM

If you do decide to apply for an ARM, the process isn’t significantly different from applying for a fixed-rate mortgage. You’ll need to work with a lender or loan broker (perhaps multiple entities if you’re shopping for rates) to determine which loan products you’re able to qualify for. You’ll need to provide plenty of documentation, including the following:

  • Social security number
  • Address
  • Proof of income and employment information
  • Recent W-2s (1099s if applicable)
  • Bank account information

The lender will determine how much they can loan you based on your credit history, current earnings, available assets, and more.

Ultimately, an ARM can be a risky loan type if you don’t have a plan for the adjustable-rate years of the loan (such as selling the property). If you’re relying on the lower payment and lower APR during the first 3-7 years, you need to have a clear plan for what happens when the rate goes up.

Need to shed in preparation of purchasing a home? We can help. Learn how you can repay debt quickly and start rebuilding your credit with a debt management plan.

Tagged in Mortgages and foreclosure

A corporate headshot of Jackie Boise.

Jackie Boies is Senior Director of Partner Relations at MMI with over 40 years of experience helping families achieve and maintain their dreams of homeownership.

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