If you’re considering buying a home right now, mortgage rates aren’t making it easy. The average rate for 30-year fixed-rate mortgages pushed past 7.5% in September.
With mortgage interest rates at the highest they’ve been in decades, some homebuyers are turning to adjustable-rate loans. Right now, average rates for ARMs are nearly 1 full point lower than the rate for 30-year fixed mortgages.
A less expensive rate on a home loan is attractive, but 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 mortgage 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 7.5% of all mortgage applications were for adjustable-rate loans, according to the most recent data from the Mortgage Bankers Association.
How do ARM loans work?
An ARM starts out just like a fixed-rate mortgage: Your payments look the same month after month. However, when the introductory 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.
How do introductory periods work?
To truly understand adjustable-rate mortgages, it’s important to get a handle on the nomenclature. With a 5/1 ARM, the five 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 identical for five years. Then, if the rate increases by 1% when the adjustable-rate period begins, your monthly payments for the next year would 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.
How do indexes and rate caps work?
Your rate isn’t just a random number that the lender decides to assign. It’s determined by two key factors: indexes and caps.
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
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.
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:
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.
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.
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 in the future 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 at a time 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 go down, but if the pandemic taught us anything, it’s that 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 in case you were to lose your job or take in less income? If not, then 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 really 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.