What Are Adjustable-Rate Mortgages?

If you’re trying to buy a home right now, interest rates have not been making it easy. While mortgage rates finally started hitting lower milestones in November, bigger relief may not happen until a bit later in 2024. 

The Fed has signaled for rate cuts in the new year, but what if you find the home you love and need to make an offer before those cuts happen? One solution may be an adjustable-rate loan. Right now, average rates for 5/1 ARMs (one of the most common adjustable-rate offerings) are around three-quarters of a point lower than the rate for 30-year fixed mortgages. 

A less expensive rate on a home loan is attractive because it translates to lower monthly payments. However, it isn’t without risk. After an introductory period of one or more years, ARMs can adjust to a higher rate, which could make your monthly mortgage payment more expensive and budgeting more difficult. Read on for everything you need to know about how ARMs work, how they differ from other types of mortgages and whether they’re a good option for you.

What are adjustable-rate mortgages?

There are many types of ARMs, but they all have one thing in common: A fixed-rate introductory period followed by a variable interest rate that will go up or down based on index movements (more on that below). This is what differentiates all ARM products from traditional fixed-rate mortgages.

The big appeal of ARMs is that the initial rate is usually lower than the rate on a traditional mortgage. With an adjustable-rate mortgage, you’re taking a gamble that the savings you collect in that introductory period will pay off, even if your rate eventually goes up. 

There still aren’t many new homeowners willing to take the gamble: Just 6.3% of all mortgage applications are for adjustable-rate loans, according to the most recent data from the Mortgage Bankers Association. 

How do adjustable-rate mortgage loans work?

An ARM starts out just like a fixed-rate mortgage: Your payments look the same month after month during your fixed-rate period. However, when that initial period is over, the interest rate changes based on a range of macroeconomic factors. Once you’re in the adjustable-rate period, your monthly payment could change significantly every year. 

Introductory periods on ARM loans

To truly understand adjustable-rate mortgages, getting a handle on the nomenclature is important. With a 5/1 ARM, the first number indicates your introductory period (five years), and the second number (the one) indicates the annual frequency with which your rate readjusts after the introductory period ends. 

For example, consider a 5/1 ARM for a loan of $300,000. With an initial interest rate of 6.4%, the monthly payment is just over $1,876, and those payments will be unchanged for five years. Then, if the rate increases by 1% when the adjustable-rate period begins, your monthly payments for the next year will jump to over $2,054. If you can’t get out of the ARM by selling or refinancing your home, you’ll be in for regular swings in your monthly mortgage payments.

Conforming vs. nonconforming ARM loans

Conforming ARM loans adhere to the standards of Fannie Mae and Freddie Mac, both of which buy loans from mortgage lenders to create liquidity in the housing market. Those standards include requirements about the borrower, such as their credit score and debt-to-income ratio. Additionally, they include how much money one can borrow to buy a home, which varies based on county. For example, conforming loan limits are much higher in places like Hawaii, California and New York City.

Nonconforming ARM loans do not follow those standards and typically involve higher amounts of money and/or borrowers in unique financial situations, such as being self-employed.

Conventional vs. government-backed ARM loans

If you’re considering an adjustable-rate mortgage, you can find conventional and government-backed ARM options. Government-backed is another way of indicating that the federal government insures these mortgages. However, you won’t borrow money directly from the government -- you’ll need to find lenders that offer FHA-backed adjustable-rate mortgages or VA adjustable-rate mortgages. If you’re looking for a USDA loan, you’re out of luck: These are only offered as fixed-rate loans.

How do indexes and rate caps work? 

Your rate isn’t just a random number the lender assigns. It’s determined by two key factors: indexes and caps.

Understanding indexes on ARM loans

Short-term rates like those for ARMs are based on a few major indexes, which set the base rate for all loans. Indexes involve more complex math than most homeowners are accustomed to performing. After all, you’re busy enough working to pay the mortgage. The most common indexes for ARMs are the Secured Overnight Financing Rate and the One-Year Treasury Constant Maturity, among others.

On top of whichever index your ARM uses, your lending institution will set a margin. This margin is usually for the life of your loan and added to your current rate when your loan adjusts. For instance, if the index is 1.5% and your lender’s margin is 2%, your effective rate is 3.5%.

Understanding rate caps on ARM loans

These indexes can change significantly over time, which leaves you vulnerable to substantial rate swings. This risk is somewhat mitigated, however, by rate caps, serving as guardrails that prevent your interest rate and loan payment from increasing too much.

Your adjustable-rate loan caps should be disclosed upfront and usually come in one of two forms:

• Periodic caps, which limit how much your rate can increase from one period to the next
• Lifetime caps, which put a lid on how much your rate can go up over the life of the loan

Although payment caps protect you from big rate hikes, they can also expose you to something dangerous: negative amortization. If the index rate is higher than your cap, your payment might not be large enough to cover the principal, and you could end up seeing your loan balance go up instead of down.

Understanding rate periods on ARM loans

5/1 and 5/6 ARM loans: For both loans, the “5” represents the initial fixed-rate period of five years. With a 5/1, the adjustments happen every year, while with a 5/6, those adjustments happen more frequently – every six months.

7/1 and 7/6 ARM loans: If you’re looking at 7/1 and 7/6 ARM options, these loans have a seven-year fixed rate period, followed by adjustments every year for a 7/1 ARM or every 6 months for a 7/6 ARM.

10/1 and 10/6 ARM loans: 10/1 and 10/6 ARMs have 10-year initial rate periods, so you’ll be locking in your fixed interest rate for a relatively long time before the one-year or six-month adjustments begin. However, these are not your best bet now: Average interest rates on 10/1 ARMs are higher than average rates for 30-year mortgages.

Common types of adjustable-rate mortgages

There are a wide variety of ARMs on the market. Here’s an overview of the most common ones:

Hybrid ARMs

These ARMs have both a fixed period and an adjustable period, as indicated in the example above. The first number indicates the fixed period (in years), and the second indicates how often the adjustable rate will be reviewed and updated. This adjustment time frame is usually one year but could be different (every six months or every five years, for example). Common types include 5/1, 7/1 and 10/1 ARMs.

Interest-only ARMs

These ARMs offer an introductory period during which you pay only interest while your principal balance stays the same. Often, you’ll have a low monthly payment during the introductory period, but it could increase significantly once you’re required to start paying off the principal, especially if your rate increases at the same time. Remember, too, that paying only interest means you aren’t accumulating any equity in the property.

Payment-option ARMs

These adjustable-rate mortgages offer considerable flexibility and a lot of risk. Lenders may offer several payment options, including paying interest and principal, only paying interest or making a minimum payment, each with its own pros and cons. Some lenders may let you select a different payment option each month. Unpaid interest on these types of loans can add up quickly, however, putting you at risk of negative amortization. 

FHA ARM Loans

You don’t need a conventional loan to opt for an ARM. FHA loans, which are backed by the Federal Housing Administration, are also available in various hybrid formats. FHA ARMs are available as one-year ARMs, as well as 3/1, 5/1, 7/1 and 10/1 options. Depending on the hybrid option, FHA ARMs have periodic caps of 1 to 2 percentage points and lifetime caps of 5 to 6 percentage points.

Reasons to consider an adjustable-rate mortgage 

Despite the risks, an ARM can be a good option for some homebuyers, especially if you plan to sell the home within a relatively short time span. They offer several advantages:

• Lower interest rates than fixed-rate mortgages: The difference varies based on market conditions, but you’re likely to get a lower initial rate on an ARM than a 30-year fixed-rate mortgage. When fixed rates are high, as they are right now, ARMs can make for a compelling alternative.

• Flexibility: If you know you’re not going to be in a home for the long haul, you can take advantage of a low introductory rate and then refinance or sell before you reach the adjustment period.

• Low introductory payments: Locking in a low monthly payment for five years (or more) can free up funds for other purposes. And if you expect to earn a higher salary in the future, a higher monthly payment may be less daunting.

• Rates and monthly payments may decrease: There’s always the chance that your rate and payment could go down -- though that’s more likely if you bought or refinanced your home when rates were high.

Reasons to avoid an adjustable-rate mortgage

There are some serious disadvantages to consider before taking on an ARM:

• Monthly payments can increase: This is the most obvious risk you’re taking with an ARM, and it can be significant, even if your loan has caps. Make sure you understand your ARM’s indexes and caps so you can calculate potential future payments.

• Negative amortization: As noted, payment caps can create a dangerous situation in which your loan balance can actually increase if you’re not paying enough toward the principal.

• Difficult to build into a budget: You may have good reason to believe that your income will increase or rates will drop, but nobody can perfectly predict what will happen in the next few years. Could you handle a payment increase even without a raise? Do you have money saved if you were to lose your job or take in less income? If not, you may want to think twice about an ARM.

• Prepayment penalties: Some ARMs have prepayment penalties to prevent you from paying any extra principal or paying off the loan in advance. Be sure to ask your lender about any payment penalties before you sign off on a loan.

• Complicated fee structure: Some lenders structure their ARMs with complicated discount points that provide an even lower rate initially. Some ARMs also have origination fees, funding fees and other costs associated with this type of mortgage product that you should talk to your lender about. This fee structure can further obscure the actual cost of your loan and make it harder to know if you’re getting a good deal.

How to apply for an adjustable-rate mortgage

If you decide to apply for an ARM, you’ll find the steps are basically the same as they would be for any loan, but you should proceed with a little extra caution.

• Review your credit and clean up any errors. If you need to improve your credit to increase your chances of locking in a better introductory rate, you may want to wait a few months. 

• Determine what you can afford in terms of money down and monthly payments. Remember that the latter can change with an ARM, so be sure you are planning with this in mind.

• Get loan estimates from several lenders so you can compare rates, fees and closing costs. If you apply with several lenders within a short period (usually 30 days or less), the credit checks won’t count as multiple inquiries on your credit report.

• Ask lenders about important aspects of ARM loans such as rate caps, negative amortization, discount points and the index used to determine your rate. Inquire about prepayment penalties as well to make sure you are a well-informed borrower.

• Compare ARM terms to your fixed-rate options. Even if you’re convinced an ARM is the best option for you, it’s always helpful to explore all of your options before making a large financial decision.

• Get preapproved for an ARM. Next, you’ll want to begin the application process and get preapproved so you can determine how much house you can comfortably afford.

• Finalize your ARM paperwork. Once you’ve been preapproved and decided on a lender, it’s time to select the product that’s best for your financial situation and sign your loan paperwork. 

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