Adjustable-Rate Mortgage Explained: Pros, Cons and How It Works

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Adjustable-rate mortgages, or ARMs, are home loans with fluctuating interest rates. The main difference between adjustable- and fixed-rate mortgages is that fixed-rate mortgages keep the same rate for the life of the loan.

ARM rates today might differ from those tomorrow, as they adjust periodically, based on an interest rate index and a margin added by the lender. Your payment increases when the index rises and decreases if the index falls.

The initial interest rate on an ARM is usually less than that of a fixed-rate mortgage — a plus for borrowers who don’t want to stretch their budgets too thin in the early months or years of their loans. Borrowers who expect interest rates to fall also might choose ARMs over fixed-rate loans.

If your ARM has a conversion clause, you’re allowed to convert it to a fixed rate when the first adjustment period ends. Lenders typically charge a fee to include this clause.

How Does an Adjustable-Rate Mortgage Work?

ARMs are more complicated than fixed-rate loans, but they aren’t difficult to understand.

Fixed Period vs. Adjustment Period

When looking ARM rates on lender websites, you’ll see two numbers separated by a slash — 5/1, for example.

The first number refers to the initial period, also called the fixed-rate period. The rate, and thus the payment, stays the same for the number of months or years indicated by the number. In this example, the fixed-rate period would last five years. Other common initial periods are six months and three, five, seven and 10 years.

The second number is for the adjustment period. This tells you how often the rate adjusts. In a 5/1 loan, the rate remains fixed for five years and then adjusts once per year for the rest of the loan term.

The Role of Index and Margin

Index and margin are the two variables that determine the interest rate on an ARM.

The index rate is a fluctuating benchmark influenced by market conditions, and it serves as a baseline for ARM rates. The margin is the lender’s mark up on on the index rate. It remains the same for the term of your loan.

If, for example, the index is 4% and the margin 1%, the ARM rate would be 5%.

Here are a few more examples:

Rate Caps and Limits

Lenders limit how much ARM rates can increase.

ARMs come with three different types of caps:

• The initial cap, which limits the first rate adjustment
• The periodic adjustment cap, which limits the increase of ARM rates in subsequent adjustments
• The lifetime cap, which limits the amount of the interest rate increase over the full life of the loan

Some ARMs also have payment caps that limit the amount your monthly payment rises when there’s an adjustment.

Pros and Cons of an Adjustable-Rate Mortgage

Adjustable rates have benefits for the right borrower, but they also have drawbacks you should consider.

Benefits of an ARM

These features could make an ARM the right choice for you:

• Lower initial interest rate compared to a fixed-rate loan: This can make your payments more affordable in the early months or years of your loan.
• Potential for savings: In addition to savings during the initial period, an ARM lets you take advantage of declining interest rates over the term of the loan.
• Good choice for short-term homeowners: The initial rate is often a promotional one that’s artificially low. This benefits homeowners planning to sell before their rates adjust.

Risk of an ARM

An ARM’s variability makes it a risky loan compared to one with a fixed rate.

• Payment uncertainty when rates adjust: Annual rate adjustments make long-range budgeting difficult
• Potential for higher costs if interest rates increase: Rates are likely to fluctuate in both directions over time. Future rate increases could offset, and even reverse, savings from a low initial rate.
• More complex than fixed-rate mortgages: Fixed-rate loans are more straightforward — your mortgage rate and payment stay the same over the entire loan term, which makes your payments easier to budget for.

Types of Adjustable-Rate Mortgages

Most ARMs have one-year adjustment periods. You have more options when it comes to the initial fixed-rate period.

5/1 ARM

This is the most common type. As noted previously, it has a fixed rate for the first five years of the loan. After that, the loan adjusts every year until the loan is paid off.

The 5/1 ARM is the best choice for borrowers who plan to sell their homes within the first five years.

7/1 ARM, 10/1 ARM and Other Variations

The 7/1 ARM and 10/1 ARM have fixed rates lasting for seven and 10 years, respectively. After that, rates adjust annually. The longer initial periods let you take advantage of the low promotional rates even if you plan to remain in your home for the longer term.

As you research lenders, you might see other ARM variations, such as 3/1 loans and loan adjustment periods of just six months. The latter would look like this: 3/6, indicating a three-year fixed rate and adjustments every six months thereafter.

Is an Adjustable-Rate Mortgage Right for You?

Selecting the right loan can be difficult because of the number of options available and the unpredictability of mortgage rates. The following can help you decide if an ARM is right for you.

When an ARM Might Be a Good Choice

An ARM could be your best option if the following are true:

• You plan to sell your home before your rate adjusts. It’s impossible to predict where rates will be even three years in the future, so selling before the first adjustment guarantees that increasing rates won’t offset your initial savings.
• Rates are expected to decline. Again, no one can predict the future. The factors that influence rates are in constant flux, and so are experts’ rate forecasts. But if rates are expected to decline over the next few years, an ARM could keep you from being locked into a higher rate.
• You expect your income to increase. A low initial promotional rate gives you time to adjust to homeownership with less strain on your budget. Future rate increases will be more manageable if you’re earning more when they hit.

When To Avoid an ARM

An ARM is best avoided if any of the following are true:

• You prefer predictable mortgage payments. Once your initial fixed-rate period ends, your ARM payment could change every year — or even six months, if that’s the adjustment period you choose.
• Rates are as low as they’re likely to be in the next several years. If this proves true, you’ll reap no benefit from stable rates and risk increasing payments the next time rates climb.
• You plan to stay in your home for many years and would prefer not to have to refinance. The longer you plan to own your home, the greater the risk there is that rates will increase before your loan is paid off.

For more help deciding, here’s a summary of how ARMs and fixed-rate loans compare.

How To Manage an ARM Effectively

Unpredictability makes ARMS riskier than fixed-rate loans, but you can take steps to mitigate the risk.

1. Understand Your Loan Terms

Review your Loan Estimate to make sure you understand the details of your loan. The estimate shows what kind of loan you have — 5/1, for example — your initial interest rate, payment amount and how frequently the rate adjusts. You’ll also see when the first adjustment will occur and the caps on that and future increases.

2. Plan for Future Payment Increases

Use the information in your Loan Estimate to budget for future increases. If your rate could increase 1% after five years, for example, you might use an online mortgage calculator to find out how much your payment will go up. Use that information to guide decisions regarding future expenses, such as tuition or auto loan payments.

3. Consider Refinancing

If you think rates might increase, or you just don’t want to take the risk, consider refinancing your ARM into a fixed-rate mortgage loan before the ARM’s initial period ends.

Keep in mind that the refinance will have the same kinds of closing costs you paid with your current loan. They typically amount to 2% to 6% of the loan amount. You can use an online calculator to find your break-even point and help you see whether a refi is worth it.

Barb Nefer contributed to the reporting for this article.

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