Adjustable-Rate Mortgages: What are they?

It’s hard to say which is more difficult, finding your dream home or financing it. In either case, one thing is for certain: having the right resources and information helps with the decision-making process. And when it comes to financing your home with a mortgage, the right information can open options you may not have considered before.  

Taking out an adjustable-rate mortgage (ARM) for your home is one of those options that when rates are low, few people consider. But when the fixed rate starts to rise, ARMs start to make a whole lot more sense. Why? Let’s first talk about what adjustable-rate mortgages are, and then we’ll discuss why they make sense for some homebuyers in certain market conditions.  

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What is an adjustable-rate mortgage?  

An ARM is a home loan with an interest rate that adjusts over time based on the market, starting with a lower rate than fixed-rate mortgages. If your goal is to get the most affordable payment at the beginning of the loan, they are a great choice.

The thing to know about ARMs is that the interest rate at the beginning is fixed for a set time period. After the initial period, your payment may go up or down. An increase in payments could affect your budget down the road, so it’s important to understand more about the differences between adjustable-rate loans and fixed-rate loans and how they work before you make the decision to use one.  

Note: Some ARM loan programs may require a higher down payment and minimum credit score so be sure to check with your mortgage consultant.

Adjustable rate vs. Fixed rate  

A fixed-rate mortgage is exactly that: fixed. The interest rate remains the same for the life of the loan. For you, that means your payment will stay the same, no matter what happens with interest rates.  

With an adjustable-rate mortgage, you will have a lower initial monthly payment because the interest rate will be lower than a fixed rate. After the introductory period, though, your payment could be affected by changing interest rates. If rates go down, you may have lower payment. However, your payment could go up when rates go up, making an ARM loan more expensive.  

The rates for fixed vs. adjustable generally vary by 1-3 percentage points at the onset of the loan, making adjustable-rate mortgages more affordable in the beginning. That difference can save you a lot of money during the fixed period for your loan, making ARMs very attractive, especially during times when the fixed rate is high.  

How does an adjustable-rate mortgage work?  

When you take out an ARM, you will have two periods to your loan: a fixed period and an adjustable period. While you are in the fixed-rate period, your rate and payment remain the same.  

Once you hit the end of your fixed period with an ARM (typically the first 3, 5,7, or 10 years of the loan), you enter the adjustment period. During this period of your loan, your interest rate can go up or down. For example, if you take out a 30-year ARM with a 10-year fixed period, you will have a lower fixed rate for the first 10 years. For the next 20 years after that, your rate becomes adjustable and will go up or down with the market, causing your payment to fluctuate.  

How do I decide if an ARM is right for me?  

There are two major factors that determine whether an ARM is going to be a good fit for you to finance your home. The first is how long you are planning to be in your home and the second is how much risk you are willing to take. Let’s look at each of these factors to learn more about how to choose between adjustable-rate mortgages and fixed-rate mortgages.  

How long will you be in your home? 

Determining how long you will be in your home can be tricky. While you may think you have found your dream home and will stay there forever, circumstances can change. You may outgrow the house or decide it’s too big. You may have a job transfer or other unexpected life events.  

Because of all these factors that influence whether people move, the average amount of time that Americans own homes is much less than 30 years. According to the National Association of REALTORS, homeowners tend to stay for 10 years. Given this statistic, opting for an ARM can save you money on your payment if you end up moving before the adjustment period starts.  

Knowing how long you plan to stay in your home will also help you choose how long your fixed period will be on your ARM. Most have the option of 3-, 5-, 7-, 10-year fixed rates, with the lowest rates given for the least number of years in the fixed period. Therefore, if you feel certain that you will stay in your home less than 10 years, choosing a3-, 5-, or 7-year fixed period will save you the most interest.  

How risk-tolerant are you?  

Because it's almost impossible to determine exactly how long you will be in your home or if you will move sooner than expected, taking out an ARM involves some level of risk. If you think you will only be there 5 years and it ends up being 15, you may end up paying a higher interest rate after the initial fixed period, and possibly paying more than you would have with a fixed rate over those 15 years.  

If you feel there is a good chance that you will move sooner rather than later, you will most likely also be comfortable choosing an ARM and saving yourself money in the short term. On the flip side, you may also feel fine with “crossing that bridge when you come to it” if the rate creeps higher after your fixed period ends. Maybe you are confident that you will be ready to move on and don’t mind being flexible.  

If you're still not sure whether an ARM is right for you, don't worry. A qualified mortgage loan officer can advise you further on whether an adjustable-rate mortgage would benefit you. They can also make recommendations on the best type of ARM to use in your situation and how that will affect your current and future payments.

What market conditions are best for adjustable-rate mortgages? 

ARMs start to become more attractive to homebuyers when the fixed rate starts to climb over 5%. When it is lower than that, there is not as much of a spread between the adjustable rate and the fixed. Therefore, you do not see as many homebuyers opting for ARMs. 

Once fixed rates are over 5%, taking out an adjustable-rate mortgage begins to make more sense for buyers. You can save a lot of money during the fixed period, when your rate will be much lower than if you had taken out a fixed-rate mortgage. And if you plan to stay in your home for a shorter time, then it will be more beneficial for you to have an ARM rather than a fixed. You can put that additional monthly savings into your monthly bills, improving your home, paying off debt, putting more toward the principal, or saving for your next home.