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When you get a mortgage, you can choose a fixed interest rate or one that changes. While fixed-rate mortgages keep the same rate and payment for the life of the loan, adjustable-rate mortgages (ARMs for short) have an introductory fixed-rate period, followed by fluctuating rates that change how much you pay. Typically, ARM loan rates start lower than their fixed-rate counterparts, then adjust upwards once the introductory period is over.
Here’s everything you need to know about ARMs: what they are, how they work and when you should take one up.
An adjustable-rate mortgage, or ARM, is a home loan that has an initial, low fixed-rate period of several years. After that, for the remainder of the loan term, the interest rate resets at regular intervals. This means that the monthly payments can go up or down.
Generally, the initial interest rate on an ARM mortgage is lower than that of a comparable fixed-rate mortgage. After that period ends, interest rates — and your monthly payments — can rise or fall.
Interest rates are unpredictable, though in recent decades they’ve tended to trend up and down over multi-year cycles. During periods of higher rates, ARMs can help you save money in the early days of your loan by securing a lower initial rate. Just keep in mind that after the introductory period of the loan, the rate — and your monthly payment — might go up.
The initial interest rate on an adjustable-rate mortgage is sometimes called a “teaser” rate, and ARMs themselves are sometimes referred to as “teaser” loans. While they’re generally one and the same, there can be a difference between a regular ARM and a riskier teaser loan that offers an extremely discounted rate upfront, followed by a dramatic change (usually upward) in the rate.
The difference between fixed-rate and adjustable-rate mortgages is simple: Fixed-rate mortgages have the same rate for the life of the loan, whereas ARMs have a rate that moves up or down after an introductory period. Other than that, they work similarly: You pay them off each month, in payments that include principal and interest and sometimes homeowners insurance and property taxes.
“Deciding between a fixed-rate mortgage and an ARM is about picking stability or flexibility,” says Linda Bell, principal writer for Bankrate’s Home Lending team. “With a fixed-rate mortgage, you get a steady interest rate and you know how much you’ll pay each month. On the other hand, the initial low rate you get with an ARM could mean lower payments early on. However, as market rates change, make sure you are prepared for potential increases down the road.”
ARMs are comprised of a few components:
ARMs come with rate caps that insulate you from possible steep year-to-year increases in monthly payments. These caps limit the amount by which rates and payments can change.
Let’s say you took out a 30-year 5/1 ARM for $350,000 with an introductory rate of 6.65 percent (the average rate as of this writing). Here’s how your payment schedule might look, assuming interest rates rose annually by. 25 percent. The ARM has a lifetime cap of 12 percent.
| Payment Number | Interest Rate | Monthly Payment |
|---|---|---|
| 1 | 6.65% | $2,246.88 |
| 60 | 6.9% | $2,298.74 |
| 72 | 7.15% | $2,349.73 |
| 84 | 7.4% | $2,399.80 |
| 96 | 7.65% | $2,448.85 |
| 108 | 7.9% | $2,496.83 |
| 120 | 8.15% | $2,543.67 |
| 132 | 8.4% | $2,589.27 |
| 144 | 8.65% | $2,633.56 |
| 156 | 8.9% | $2,676.46 |
| 168 | 9.15% | $2,717.86 |
| 180 | 9.4% | $2,757.67 |
| 192 | 9.65% | $2,795.80 |
| 204 | 9.9% | $2,832.13 |
| 216 | 10.15% | $2,866.54 |
| 228 | 10.4% | $2,898.92 |
| 240 | 10.65% | $2,929.13 |
| 252 | 10.9% | $2,957.05 |
| 264 | 11.15% | $2,982.54 |
| 276 | 11.4% | $3,005.44 |
| 288 | 11.65% | $3,025.60 |
| 300 | 11.9% | $3,042.87 |
| 312 | 12% | $3,048.55 |
| Total payments: $968,125 | ||
| Total interest: $618,125 | ||
Helps estimate how your ARM payment can shift in a variety of scenarios
ARMs are generally 30-year mortgages, but they can vary a lot in how often the fixed rate lasts and how often the rates change once you’re into the variable-rate period. Here are the most typical loan terms:
Along with these common loan terms, there are three main types of ARMs: hybrid, interest-only and payment-option.
A hybrid ARM is the traditional adjustable-rate mortgage. The loan starts with a fixed interest rate for a few years (usually three to 10), and then the rate adjusts up or down on a preset schedule, such as once per year.
Interest-only ARMs are adjustable-rate mortgages in which the borrower only pays interest (no principal) for a set period. Once that interest-only period ends, the borrower starts making full principal and interest payments.
The interest-only period might last a few months to a few years. During that time, the monthly payments will be low (since they’re only interest), but the borrower also won’t build any equity in their home (unless the home appreciates in value).
With a payment-option ARM, borrowers select their own payment structure and schedule, such as interest-only; a 15- 30- or 40-year term; or any other payment equal to or greater than the minimum payment. (The minimum payment is based on a typical 30-year amortization with the initial rate of the loan.)
A payment-option ARM, however, could result in negative amortization, meaning the balance of your loan increases because you aren’t paying enough to cover interest. If the balance rises too much, your lender might recast the loan and require you to make much larger, and potentially unaffordable, payments.
There are several reasons why an ARM may be the right choice for you:
However, if you’re going to stay in your home for decades, an ARM can be risky. If you don’t refinance, your mortgage payments may rise significantly once the fixed-rate period ends. If you’re buying your forever home, think carefully about whether an ARM is right for you.
Learn more: The pros and cons of ARMsTo set ARM rates, mortgage lenders take an index rate and add a stated number of percentage points, called the margin. The index rate can change, but the margin does not.
For example, if the index is 4.25 percent and the margin is 3 percentage points, they are added together for an interest rate of 7.25 percent. If, a year later, the index is 4.5 percent, then the interest rate on your loan will rise to 7.5 percent.
The basic requirements for an ARM loan include a credit score of at least 620 and a debt-to-income ratio (DTI) of 50 percent or less. Further requirements depend on whether you get a conventional, FHA or VA ARM loan.
Refinancing an ARM to a fixed-rate mortgage is a fairly common thing to do. Keep in mind that refinancing isn’t free, though — you’ll pay closing costs, just as you did on your original loan. Ideally, to recoup those costs, you want to refinance to a significantly lower rate, shortening your break-even period.
Andrew Dehan writes about real estate and personal finance. His work has been published by Rocket Mortgage, Forbes Advisor and Business Insider. He’s also a poet, musician and nature-lover. He lives in metro Detroit with his wife and children.
