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Adjustable-rate Mortgages

 

What You'll Learn

  • If you are considering an adjustable-rate mortgage (ARM), it’s important to know that your payment and may go up over time
  • If you plan on living in your home for less time than the adjustment period, an ARM might be good for you
  • The interest rate on a 3/1 ARM may change after three years and once every year for the life of the loan

An ARM is a loan with an interest rate that will change throughout the life of the loan. An ARM may start out with lower monthly payments than a fixed-rate mortgage, but you should know that:

  • Your monthly payments may go up over time and you will need to be financially prepared for the adjustments.
  • Your payments may not go down much, or at all, even if interest rates drop.
  • You might incur a penalty if you try to pay off the loan early in the hope of avoiding higher payments.

All ARMs have adjustment periods that determine when and how often the interest rate can change. There is an initial period during which the interest rate doesn't change – this period can range from as little as six months to as long as 10 years. After the initial period, most ARMs adjust. The most common ARMs are 3-, 5-, and 7-year ARMs. To help you understand how ARMs work, consider the following example:

A 3/1 ARM has a fixed interest rate for the first three years. After three years, the rate can change once every year for the remaining life of the loan. The same principle applies for a 5/1 and 7/1 ARM. If the rates increase, your monthly payments will increase; however, if rates go down, your payments may not decrease, depending upon your initial interest rate.

Most ARMs also typically feature an adjustment "cap" which limits how much the interest rate can go up or down at each adjustment period. For instance:

A 7/1 ARM with a 5/2/5 cap structure means that for the first seven years the rate is unchanged, but on the eighth year your rate can increase by a maximum of 5 percentage points (the first "5") above the initial interest rate. Every year thereafter, your rate can adjust a maximum of 2 percentage points (the second number, "2"), but your interest rate can never increase more than 5 percentage points (the last number, "5") throughout the life of the loan.

When considering an ARM, ask yourself:

  • If the mortgage rate increases, can I afford a higher mortgage payment? Use our calculator to estimate how a higher mortgage rate can impact your mortgage payment.
  • Do I plan to live in my home for less than five years – or less than the adjustment period? If yes, this mortgage may be right for you.

To determine the best type and structure ARM for your situation, lean on your lender or financial professional for guidance. Be sure you know the details of how and when this type of loan may change your monthly payments.

 

Key TakeAways

  1. ARMs may start out with lower monthly payments than fixed-rate mortgages, but you need to be prepared for them to increase

  2. If you're thinking about securing an ARM, it’s important that you understand mortgage rates

  3. ARMs are not for everyone – evaluate the option carefully with your lender

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