Shopping for a mortgage? You might hear about two options: fixed-rate and adjustable-rate mortgages (ARM). And you’re probably also wondering what do these words even mean? A fixed-rate mortgage is probably the more straightforward option: You pay a fixed interest rate over the life of the loan. But with an adjustable-rate mortgage the rate definition isn’t as simple.
By now, you may be asking yourself questions like:
- What is an adjustable-rate mortgage?
- What do those 5/1, 10/6, 5/5 numbers mean?
- If the rate adjusts, how much interest will I wind up paying?
- Can the lender charge me any interest they want?
- Didn’t people get into trouble with adjustable-rate mortgages during the Great Recession?
- My parents have a fixed-rate mortgage. Why does an adjustable-rate mortgage make sense for me?
Well, lucky for you, we can help answer those questions.
What Is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage (ARM) is usually a 30-year mortgage that offers a lower interest rate (sometimes referred to as a teaser rate) during an introductory period and then “adjusts” over time. The introductory period usually lasts for 3 to 10 years and then adjusts every year (or every couple of years) after that.
How Does an Adjustable-Rate Mortgage Work?
When you shop for an ARM, you’ll see an interest rate that looks like this:
5/1 ARM 3.0% APR
The first two numbers with the slash represent: length of the introductory period in years / number of years between rate adjustments.
So, if you get a 5/1 ARM, you would get the introductory rate of 3.0% for the first 5 years. After that, the rate would adjust every year and become a variable rate.
What Determines the Variable Rate?
Okay, so what will the variable rate be? The truth is, no one – including the lender – knows for sure. But it won’t be completely random! The variable interest rate will be based on three factors:
- Index rate
- Adjustment caps and lifetime ceiling
The index rate for your mortgage is the biggest wild card in the adjustable-rate mortgage formula because it’s based on existing interest rates decided by the Federal Reserve aka “The Fed.” To help ease your mind about the index rate, consider the following:
- The Fed knows that changing interest rates by even a quarter of a percentage point can affect the global economy, so these changes are made very slowly and deliberately.
- Your lender will use an existing index used worldwide to determine your index rate, and it will be spelled out in your mortgage agreement.
- After the Great Recession of 2008, the Dodd-Frank Act put new restrictions on mortgage lenders, expanded oversight and created new rules to protect borrowers. Hopefully, this gives you a little peace of mind.
The margin is the amount above the index rate that the lender is charging you to borrow. Like the interest rate with most mortgages, this number will be based on your creditworthiness. The better your credit, the lower your margin rate.
Adjustment caps and lifetime ceiling
Most mortgages have adjustment caps and a lifetime ceiling that will act as guardrails to keep borrowers from getting stuck with payments they can’t afford.
According to the Consumer Financial Protection Bureau, an ARM should include three kinds of caps and a lifetime ceiling:
- Initial adjustment cap: Limits the interest rate increase after the first adjustment by 2% to 5%.
- Subsequent adjustment cap: Limits the interest rate increase in later adjustment periods by 2%.
- Lifetime adjustment cap: Limits the interest rate increase over the life of the loan, usually to 5%.
- Lifetime ceiling: Limits the maximum interest rate that the lender can charge over the life of the mortgage. If your lifetime cap is 8%, your lender can never charge more than that, even if the interest rates are higher.
Before you sign up for an ARM, make sure you know your margins, caps and ceilings, and be ready for every potential mortgage adjustment. While you can wing that weekend getaway with your friends, it’s probably wise to plan for all the adjustments you may see if you take out an ARM loan.
Breaking Down an Adjustable-Rate Mortgage
Now that you know the terms, let’s take an ARM for a test drive, shall we? You want to get a mortgage, but for whatever reason, the lender can only offer you 5% on a fixed-rate mortgage. This really isn’t aligned with your plan, so you start exploring other options.
Let’s consider a 5/1 ARM with a 3% APR.
For the first 5 years, you get a 3% rate, which lowers your monthly mortgage payments for those first 5 years. It seems like a good deal, and you agree to a 2% margin on your mortgage.
At the start of year 6:
- Interest rates drop from 5% to 1%. With your 2% margin, your interest rate will stay at 3%, keeping your monthly payments the same for the next year.
At the start of year 7:
- Interest rates rise to 6%. With your 2% margin, your interest rate will jump to 8%, more than doubling the amount of interest you’re paying on your mortgage for the next year.
At the start of year 8:
- Interest rates rise to 7%. With your 2% margin, your interest rate should jump to 9%, but the lifetime cap keeps that number at 8%.
At the start of year 9:
- Interest rates drop again to 3%. With your 2% margin, you’re back to the 5% interest rate that you would have been paying with a fixed-rate mortgage.
With an ARM, the adjustment cycle will repeat until you pay off your mortgage or you refinance.
What Are the Advantages of an Adjustable-Rate Mortgage?
Given the uncertain nature of an ARM, you may be wondering why you should consider one?
Here are a few scenarios where an ARM can work to your advantage.
Buying a starter home
Say you’re going to buy a condo or starter home in a hip area with a mediocre school district. You figure you’ll stay for 5 years, build up equity and move to the suburbs when the kids are ready for elementary school. An ARM could lower your initial interest rate and allow you to build up equity faster. If home prices in your current neighborhood rise, you’ll be able to get more money from the sale of your home that you can use to buy your next home.
Debt or credit issues
We get it. Your initial “adult” years were rough on your finances. Whether you went through a rough patch where you couldn’t find work and you leaned on your credit cards or you took out more student loans, your credit score took a hit. Using an ARM may allow you to get an affordable mortgage while you repair your credit. Once your score improves, it will be easier to refinance, and you might have more mortgage options available to you.
High interest rates
Due to inflation, The Fed has raised interest rates. Even with excellent credit, the best interest rate lenders can offer you on a fixed-rate mortgage is 7%. Then, your trusty lender offers you an adjustable-rate mortgage with an introductory 5% interest rate. Five years later, rates have gone down again and your mortgage payment actually goes down. Or maybe refinancing is in the cards, and you’re able to score a lower interest rate for the life of the mortgage.
What Are the Disadvantages of an Adjustable-Rate Mortgage?
The biggest disadvantage of an adjustable-rate mortgage (ARM) is that no one can know how the economy will shift from day to day, let alone from year to year. The only thing you can try to account for is yourself. Before opting for an adjustable-rate loan you should ask yourself these questions:
- How long do I plan to own this home?
- Are interest rates likely to go up or down over the next 10 years?
- If I’m dealing with credit issues, do I have a realistic plan to improve my situation?
- Am I financially ready to buy a home, or should I wait?
- Do I expect my income to increase or stay stable in the next few years?
- How much of my income do I need to budget toward student loans or other debt?
While a fixed-rate mortgage provides greater stability, with careful planning and consideration, an ARM can be a smart way to buy more home for less money, pay less interest over time and get a better deal on your mortgage than current rates may allow for.