An adjustable-rate mortgage (ARM) is a loan with an interest rate that will change throughout the life of the mortgage. This means that over time, your monthly payments may go up or down.
While both fixed-rate and adjustable-rate mortgages have benefits to consider, you need to make sure you are financially prepared for the rate adjustments that might happen with an ARM.
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.
How do ARMs work?
Let's take a look at an example:
- A 3/1 ARM has a fixed interest rate for the first three years. After three years, the rate can adjust 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") over the life of the loan.
What happens when your ARM adjusts?
If you currently have an ARM that is scheduled to adjust its interest rate soon, you should answer the questions below. This will help you determine if your current mortgage still makes sense for you or if you should consider refinancing to a fixed-rate mortgage.
If the mortgage rate increases, can I afford a higher mortgage payment?
If the answer is no, you may want to consider refinancing to a fixed-rate mortgage to lock in a stable mortgage at today's low rates. See how adjustable-rate mortgages compare to fixed-rate mortgages.
How much longer do you plan on living in your home?
If you plan on moving soon, it may make financial sense to stick with an ARM. But, should your plans change in the future, you will still be responsible for making your monthly mortgage payments if rates adjust upwards. Use our calculator to estimate how a higher mortgage rate can impact your mortgage payment.
When it comes to mortgages, you have options. To determine the right mortgage 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.
To learn more about your mortgage options, visit My Home by Freddie Mac.