Considering an Adjustable-Rate Mortgage? Here’s What You Should Know

Adjustable-rate mortgages have benefits and drawbacks that you should carefully consider when choosing a home loan. Learn about how ARMs work, the different types of ARMs, when an ARM may be a good option, and when to think about refinancing to a fixed-rate mortgage.

How Do ARMs Work?

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.

This is different from a fixed-rate mortgage (FRM), which has a fixed interest rate that is set when you take out the loan and does not change. With this type of loan, your monthly payments will not change.

ARMs have two distinct periods:

• Initial period: Also known as the fixed-rate period, during this time, the interest rate on your loan doesn't change. The initial period can range from six months to 10 years. The most common ARM terms will have an initial period of 3, 5 or 10 years.

After the initial period, most ARMs adjust. Simply put, when your loan adjusts, your interest rate may change.

• Adjustment period: All ARMs have adjustment periods that determine when and how often the interest rate can change. Your adjusted rate will be based on your individual loan terms and the current market.

You need to make sure you are financially prepared for rate adjustments if you are considering an ARM.

What Are the Different Types of ARMs?

There are different types of ARMs that lenders offer. The name of these ARMs will indicate:

• The duration of the initial period.
• How often in a year your rate can adjust during the adjustment period.

Let’s look at an example: The most common adjustable-rate mortgage is a 5/1 ARM. This means you will have an initial period of five years (the “5”), during which the interest rate doesn’t change. After that time, you can expect your ARM to adjust once a year (the “1”).

Most ARMS will also typically offer a rate cap structure, which is meant to limit how much your rate can increase or decrease.

There are three different caps:

• Initial cap: Limits how much your rate can increase when your rate first adjusts.
• Periodic cap: Limits how much your rate can increase from one adjustment period to the next.
• Lifetime cap: Limits how much your rate can increase or decrease over the life of your loan.

Let’s say you have a 5/1 ARM with a 5/2/5 cap structure. This means on the sixth year — after your initial period expires — 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.

When shopping for an ARM, you should look for interest rate caps you can afford.

When Should You Consider an ARM?

Many homeowners choose an ARM to take advantage of the lower mortgage rates during the initial period. You may consider an adjustable-rate mortgage if:

• You plan on moving or selling your home within five years, or before the adjustment period of the loan.
• Interest rates are high when you buy your home.

If rates are low, it would make more sense to get a fixed-rate mortgage to lock in the low rate.

Keep in mind that, with an ARM, there is a level of uncertainty about how much your monthly payment will go up or down. Depending on the market, your rate could adjust upward and increase your monthly payments. It is important to be mindful of this because you are still responsible for making your monthly payments if your rate adjusts upward.

When Should You Consider Refinancing to a Fixed-Rate Mortgage?

Switching from an adjustable-rate mortgage to a fixed-rate mortgage is one of the most common reasons homeowners choose to refinance.

You may want to refinance your ARM into a FRM if:

• Your ARM is scheduled to adjust soon. This is especially important if you cannot afford a higher monthly mortgage payment.
• Mortgage rates are low. This will help you lock in a low rate and take advantage of the stability of a fixed-rate mortgage.

Alternatively, if you plan to move soon, it may make financial sense to stick with an ARM.

Before you make plans to refinance later, it’s important to take into account the costs of refinancing — which are similar to what you pay when you purchase a home — and any penalties you may face if you refinance too soon.

Some ARMs may require you to pay fees or penalties if you refinance or pay off the ARM early, usually during the initial period (the first three to five years) of the loan. Prepayment penalties can total several thousand dollars. It’s important to know about these potential extra fees before you take out an ARM.

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.