What is an adjustable-rate mortgage (ARM)?

The type of interest rate on your mortgage affects how much you pay each month. When it’s time to take out a loan to buy a home, you can choose between a fixed-rate mortgage or an adjustable-rate mortgage. An adjustable-rate mortgage (ARM), also called a variable-rate mortgage or hybrid ARM, is a home loan with an interest rate that adjusts periodically based on the market.

ARMs typically have a lower initial interest rate than fixed-rate mortgages, so an ARM is a money-saving option if you want the lowest possible mortgage rate from the start. The low initial interest rate won’t last forever, though. Once it ends, your monthly payment adjusts periodically, resulting in unpredictable monthly mortgage payments that are harder to factor into your budget. Taking time upfront to understand how ARMs work can help prepare you if your rate starts to climb.

How does an adjustable-rate mortgage work?

ARMs are long-term home loans with two periods: a fixed period and an adjustable period.

• Fixed period: During the fixed period, your interest rate does not change, and this typically lasts for 3, 5, 7, or 10 years.
• Adjustment period: After the fixed-rate period expires, your interest rate can go up or down based on changes with the market. With many ARMS, your interest rate will adjust either every 6 or 12 months.

For example, if you take out an ARM with a 5-year fixed period, the interest rate would be fixed for the first 5 years of the loan. After that, your rate would adjust up or down for the remaining 25 years of the loan, if you’ve opted for a 30-year term.

Types of ARMs

ARMs are typically advertised as a figure with two numbers. The first number tells you the length of time that your initial interest rate will remain the same, and the second number tells you how often your interest rate will change after that.

• 5/1 ARM: A fixed interest rate for the first 5 years and then the rate will adjust once a year.
• 5/6 ARM: A fixed interest rate for the first 5 years and then the rate will adjust every 6 months.
• 7/1 ARM: A fixed interest rate for the first 7 years and then the rate will adjust once a year.
• 7/6 ARM: A fixed interest rate for the first seven years and then the rate will adjust every 6 months.
• 10/1 ARM: A fixed interest rate for the first 10 years and then the rate will adjust once a year.
• 10/6 ARM: A fixed interest rate for the first 10 years and then the rate will adjust every 6 months.

Remember, interest rates rise and fall and there’s no way to know where rates will be when your fixed period ends. If you take out mortgage with an adjustable interest rate, you should prepare to cover a higher mortgage payment in your budget.

How are ARM rates determined?

The interest rate you are offered on a mortgage will depend on a variety of personal factors, including your:

• Credit score.
• Home price.
• Loan amount.
• Down payment.
• Loan term.
• Interest rate type.
• Home location.
• Loan type.

Your interest rate will also be affected by market conditions. With an ARM, lenders use two other figures to determine how your interest rate will adjust after the fixed period ends: the index and the margin. The index is an interest rate that changes based on the market, while the margin is a number set by your lender when you take out your loan

Index rate + Margin = Your mortgage interest rate

Index

The index on an ARM is an interest rate that moves with the market. Changes to the index change your interest rate and monthly payment. If interest rates go up, so do your payments. If interest rates drop, your payments may go down – but not always. The index on your ARM will be tried to a broader measure of rates like the U.S. Treasury or the Secured Overnight Financing Rate. Both are typically among the lower and more stable benchmark rates.

Margins

The margin is a fixed percentage a lender adds to the current index to determine your ARM interest rate. Several factors determine your margin, including your credit score and credit history. With good credit, you’ll likely qualify for a lower margin. Riskier loans may have a higher margin to account for the possibility of a borrower defaulting. Your lender will set the margin in your loan agreement and it won’t change after that.

Rate caps

Fortunately for borrowers, ARMs often feature a critical safeguard: interest rate caps. A rate cap limits the maximum amount your interest rate can increase during each adjustment period and overall, based on your initial rate. This protects you from dramatic increases and makes adjustments more manageable.

In the real estate industry, you may encounter a set of three numbers determined by a mortgage lender, such as 2/2/5. This series of numbers represents the details of your rate caps, each applying to a different phase of your ARM loan. The three separate caps are:

• The initial adjustment cap: The first “2” is the cap on your interest rate during the first adjustment period. In other words, the new rate can’t increase by more than 2% after the introductory fixed-rate period ends.
• The subsequent adjustment cap: The second “2” is the cap on future rate adjustments. Generally, 2% is the standard subsequent adjustment cap.
• The lifetime adjustment cap: The “5” specifies how much the interest rate can increase in total over the life of the loan. In other words, the ARM’s interest rate can never exceed your initial rate plus 5%.

Most ARMs offer a 5% lifetime adjustment cap. Some lenders, though, may have higher lifetime caps, resulting in an even more expensive loan. If you’re considering an ARM, make sure you understand your lender’s rate caps and are ready to cover higher monthly mortgage payments if interest rates skyrocket.

Conforming vs. nonconforming ARMs

Beyond an ARM’s loan term, you’ll also need to decide between conforming loans and nonconforming loans as you explore your options. Conforming loans come with limits and eligibility requirements that are set by the government. Nonconforming loans are less standardized, and eligibility requirements will vary.

Conforming ARM

Conforming loans are mortgages that meet specific criteria that allow lenders to sell them on the secondary mortgage market.  Lenders sell their conforming loans – mortgages that meet the loan guidelines of Fannie Mae, Freddie Mac and the Federal Housing Finance Agency – to Fannie and Freddie to resell to investors.

For example, Fannie Mae requires a minimum credit score of 620 and a maximum debt-to-income ratio of 50% to get a conforming loan. You’ll also need a down payment of at least 3%.

Nonconforming ARM loans

Loans that don’t meet these specific guidelines are nonconforming. There are many reasons some borrowers choose a nonconforming loan. For example, a borrower may need a jumbo loan to purchase a home in a high-cost area that exceeds the FHFA’s loan limits.

However, some nonconforming loans are geared toward borrowers with lower credit scores that don’t meet conforming loan requirements. Beware that some of these nonconforming loans come with higher interest rates and risky features. For example, with some nonconforming loans, your loan balance can actually increase over time. If you’re considering a nonconforming ARM, don’t sign on the dotted line until you’ve read the fine print on rate adjustments and caps.

Nonconforming conventional and government-backed ARMs

A conventional loan is a mortgage that isn’t backed by a government agency, such as the Department of Veterans Affairs (VA), Federal Housing Administration (FHA) or the U.S. Department of Agriculture (USDA). Conventional loans are considered less risky for lenders because they can be bought by Fannie Mae and Freddie Mac, as a result, you can score a competitive interest rate with a conventional ARM.

If you use a government-backed loan, like an FHA ARM or a VA ARM, your mortgage is nonconforming under Fannie Mae and Freddie Mac’s rules. However, some home buyers can benefit more from a government-insured mortgage because the loans have different qualifying criteria and benefits. For example, government-backed loans can be available to borrowers with lower credit scores or even no down payment.

Refinancing an ARM

An ARM can be the right fit for some situations, but what if your financial circumstances change? You can refinance your ARM into a fixed-rate mortgage to lock in more stability than an ARM can offer. If you refinance before the fixed period ends, you can avoid a jump in your monthly payment.

Thankfully, the process is relatively straightforward. When you refinance, you take out a new loan to pay off the original mortgage. Once the original mortgage is paid off, you start paying off the new mortgage.

Since a new mortgage is involved, you’ll go through many of the steps you took when you applied for your original loan. For example, your lender will likely request proof of income, such as pay stubs and bank statements, and require details on your debts. This also means you’ll have to pay closing costs again. It may take some time for you to break even on these upfront costs before you’ll begin saving money.

Explore today’s interest rates to see if now is a good time to refinance to a fixed-rate mortgage. If rates are higher than your current ARM, it may not be the right time to make the switch.

Advantages of an ARM

Adjustable-rate mortgages can be the right choice for borrowers who want to enjoy the relatively low rates many lenders offer for the initial period.

• More money in the budget: The lower introductory rate on an ARM can make homeownership more affordable during the fixed period. This can be especially useful for borrowers who expect their income to increase in the coming years.
• Save and invest: The money you save from your initial lower monthly ARM payments can help you build your savings and work toward other financial goals. You can also use your savings to safeguard your finances if your interest rate spikes after the initial period.
• Pay down your principal faster: Take advantage of your low introductory monthly payments by putting the extra money you save toward your principal loan balance each month to pay off your loan faster.
• Buy a starter home: Many buyers purchase a starter home to enjoy the lower monthly mortgage payments ARMs offer as they plan to upgrade to a larger home. The risks of an ARM are relatively minimal if they can sell the starter home before the interest rate starts adjusting.
• Rates could drop: If you took out your ARM during a time when interest rates are relatively high and then they drop before your introductory period ends, your monthly payment may not increase and could even decrease.

An ARM may be the best mortgage option if you’re moving somewhere you don’t anticipate living for more than 5 years and are looking for the lowest interest rate on a mortgage.

Disadvantages of an ARM

It’s important to know that ARMs also come with potential downsides.

• Rates can go up: The biggest risk of an ARM is the odds of your interest rate increasing. If your rate goes up, your monthly mortgage payments will go up, too.
• Less predictable payments: It can be difficult to budget long term when your interest rate and monthly payments fluctuate. If your rate rises, you may struggle to make the higher monthly payments. The possibility of future rate adjustments can be a concern for some home buyers.
• Your mortgage may cost more overall: If rates do increase, then you may end up paying more overall for an ARM than if you’d initially taken out a fixed-rate mortgage instead.

How to qualify for an ARM

The exact requirements for an ARM will vary depending on the lender, but here are some general eligibility criteria you can expect:

• Minimum 5% down payment.
• Minimum credit score of 500 to 620 depending on loan type.
• Debt-to-income ratio no higher than 50%.
• Closing costs that range 3% to 6% of the purchase price.

The bottom line: An ARM can work for some home buyers

If you’re taking out a mortgage to buy a home, you’ll need to decide if you’d prefer a fixed or adjustable interest rate. In many cases, the right answer for you will have to do with your own financial situation and current market conditions. An adjustable-rate mortgage comes with a lower interest rate to start, but you’ll have to be prepared for potentially higher payments once the fixed period ends.

If you think an adjustable-rate mortgage is the right loan option for you, then you can start your approval for an ARM loan today.