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What Is An Adjustable Rate Mortgage?

Miranda Crace8-minute read

November 18, 2021

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Homeownership marks the start of your next chapter. Before you can dive into the home of your dreams, you’ll need to decide which mortgage will work best for your financial goals. One of those options is an adjustable-rate mortgage. But what is an adjustable-rate mortgage? Let’s explore this option so that you can decide if it is right for you.

Adjustable-Rate Mortgage Definition

An adjustable-rate mortgage is a home loan with an interest rate that adjusts over time based on the market. ARMs typically start with a lower interest rate than fixed-rate mortgages, so an ARM is a great option if your goal is to get the lowest possible rate.

 

However, the initial low interest rate won’t last forever. After the initial period, your monthly payment can fluctuate, which can make it difficult to factor into your budget.

 

Luckily, taking the time to understand how ARMs work can help you be prepared in case your rate goes up.

Fixed- Vs. Adjustable-Rate Mortgage

As a prospective homebuyer, you’ll be able to choose between a fixed-rate mortgage and an adjustable-rate mortgage. So what’s the difference between these mortgages?

A fixed-rate mortgage can offer more certainty because it retains the same interest rate for the life of the loan. That means that your monthly mortgage payment will stay constant for the life of the loan.

On the other hand, an ARM may charge less interest during the introductory period, thus offering a lower initial monthly payment. But after that initial period, changing interest rates will impact your payments. If interest rates go down, ARMs can become less expensive than fixed-rate mortgages; but an ARM can become relatively more expensive if rates go up.

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How Does An Adjustable-Rate Mortgage Work?

ARMs are long-term home loans with two different periods, called the fixed period and the adjustable period.

  • Fixed period: First, there’s an initial fixed-rate period (typically the first 5, 7 or 10 years of the loan) in which your interest rate won’t change.
  • Adjustment period: Then, there’s a period in which your interest rate can go up or down based on changes in the benchmark. (More on benchmarks soon.)

For example, let’s say that you take out a 30-year ARM with a 5-year fixed period. That would lead to a fixed rate for the first 5 years of the loan. After that, your rate could go up or down for the remaining 25 years of the loan.

Conforming Vs. Nonconforming ARMs

Beyond the loan term, you will encounter conforming loans and nonconforming loans as you explore your ARM options.

Conforming loans are mortgages that meet specific guidelines that allow them to be sold to Fannie Mae and Freddie Mac. Lenders can sell mortgages that they originate to these government-sponsored entities for repackaging on the secondary mortgage market if they conform to their rules.

If a loan doesn’t meet these specific guidelines, then it will fall into the nonconforming category. But beware of the potential pitfalls before jumping into a nonconforming loan! Although there are good reasons why borrowers may need a nonconforming mortgage, and most originators of these loans are reputable, many are not. If you’re considering a nonconforming ARM, read the fine print about rate resets very carefully and make sure you understand how they work.

One corollary to this is that FHA and VA ARMs are considered nonconforming according to the rules of Fannie Mae and Freddie Mac, but they have the full backing of the U.S. government. With the might of the federal government’s backing, you might be more comfortable choosing one of these loans if they’re available to you.

ARM Rates And Rate Caps

Mortgage rates are determined by a variety of factors. These include personal factors like your credit score and the broader impacts of economic conditions. Initially, you may encounter a teaser rate to entice you with an incredibly low rate which will disappear at some point during the loan term.

The basis on an ARM’s rate is the benchmark it names in the contract. For example, the contract may name the U.S. Treasury or the secured overnight finance rate (SOFR) as a rate benchmark. Essentially, the benchmark will serve as the starting point of any reset calculations.

U.S. Treasury and SOFR rates are among the lowest rates possible for short-term loans to their most creditworthy borrowers, generally governments and large corporations. From that benchmark, other consumer loans are priced at a margin, or markup, to these cheapest possible loan rates.

The margin applied to your ARM depends on your credit score and credit history, as well as a standard margin that recognizes mortgages are inherently riskier than the types of loans indexed by the benchmarks. The most creditworthy borrowers will pay close to the standard margin on mortgages, and riskier loans will be further marked up from there.

The good news is that there may be rate caps in place, which indicates a maximum interest rate adjustment allowed during any particular period of the ARM. With that, you’ll have more manageable swings with each new rate change.

Refinancing An ARM

An ARM can be the right fit for some situations. But what if your financial circumstances change? You can pursue refinancing into a fixed-rate mortgage to lock in more stability than an ARM can offer.

Luckily, the process is relatively straightforward. By refinancing, you’ll take out a new loan to pay off the original mortgage. From there, you’ll start paying off the new mortgage.

Since a new mortgage is involved, you’ll need to go through many of the same steps you took when applying for your original mortgage. For example, you’ll likely need to provide pay stubs, bank statements, and tax returns.

With attractive interest rates available, now might be a good time to consider locking in a low rate for the duration of your loan. 

Different Types Of ARM Loans

If you are interested in an ARM, there are several different arrangements to choose from. Here’s a closer look at your options.

5/1 And 5/6 ARMs

5/1 and 5/6 ARM loans offer a fixed interest rate for the first 5 years of the loan term. The second number refers to how often the rate adjusts after the first 5 years. For a 5/1 ARM, the rate adjusts once a year. With a 5/6 ARM, the rate adjusts every 6 months.

There may also be rate caps associated with the loan.

So, what’s a rate cap?

In the real estate industry, you may see the term 5/1 (2/2/5) used to refer to a 5/1 ARM.

The second set of numbers - 2/2/5 - refers to details of the rate caps. These include:

  • Initial adjustment cap: The first “2” is the cap, or limit, on how much your first reset can adjust your interest rate. In other words, at the first reset, after the 5-year introductory period, your ARM may reset your interest rate by 2% in Year 6.
  • Subsequent adjustment cap: The second “2” is the limit on how much your subsequent rate resets can increase your interest rate. Generally, 2% is the standard subsequent adjustment cap. That means that in Year 7, your interest rate may rise again by as much as 2%.
  • Lifetime adjustment cap: This is the cap that tells you how much the interest rate may increase in total over the lifetime of the loan. In our example, in Year 8 and thereafter, the interest rate can only increase by 1% total: 5% (total lifetime cap) - 2% (Year 1 adjustment) - 2% (Year 2 adjustment) = 1%

Most ARMs offer a 5% lifetime adjustment cap, but there are higher lifetime caps that could ultimately cost you much more. If you’re considering an ARM, make sure you completely understand how rate cap quotes are formatted and how high your monthly payments could get if interest rates climb.

7/1 And 7/6 ARMs

7/1 and 7/6 ARMs offer a fixed rate for 7 years. With a 30-year term, that would lead to fluctuating payments based on changing interest rates for 23 years after the initial fixed-rate period expires.

Remember, the interest rate could rise or fall, which will lead to a higher or lower mortgage payment to cover in your budget.

10/1 And 10/6 ARMs

10/1 and 10/6 ARMs have a fixed rate for the first 10 years of the loan. After that, the interest rate will fluctuate based on market conditions. If you take out a 30-year term, that will lead to 20 years of changing payments.

Today's Rates

Loan Option Rate / APR
15 year fixed* 2.375% / 2.77%
These rates are current as of 5:37 PM UTC on December 5, 2021

Advantages Of An Adjustable-Rate Mortgage

Adjustable-rate mortgages can be the right move for borrowers hoping to enjoy the lowest possible interest rate. Many lenders are willing to provide relatively low rates for the initial period. And you can tap into those savings.

Although it may feel like a teaser rate, your budget will enjoy the initial low monthly payments. With that, you may be able to put more toward your principal each month.

This added wiggle room to your budget can be the exact right option for buyers who are planning to move to a new area fairly shortly after buying a home. For example, if you plan to sell the home before the interest rate begins to adjust, those potential adjustments might not be a problem for your budget.

Buyers seeking starter homes can also enjoy these benefits because you are planning to upgrade to a larger home when you can. If those plans allow you to sell the original home before the interest rate begins to fluctuate, then the risks of an ARM are relatively minimal.

The flexibility you can build into your budget with the initial lower monthly payments offered by an ARM gives you the chance to build your savings and work toward other financial goals. Although there is the looming chance of an interest rate hike after the initial period, you can build savings along the way to safeguard your finances against this possibility.

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How To Qualify For An ARM Loan

As with all mortgages, you’ll need to meet several different requirements in order to qualify for an ARM.

You should be prepared to prove your income. The level of income you have will help the lender determine how large of a mortgage payment you can qualify for. 

Additionally, you’ll need to have a relatively good credit score to qualify. For example, most loans will require at least a 620 FICO® Score.

Who Should Consider An ARM?

Most people like certainty and, especially with today’s low interest rates, opt for fixed-rate mortgages.

However, for some home buyers, particularly those who move often or are buying starter homes, ARMs may make more sense. If you’re not buying your forever home, then buying a house with an ARM and selling it before the fixed-rate period ends can mean a lower mortgage payment.

Of course, there is always the risk that you won’t be able to sell the house before your rate adjusts. If that happens, you may want to consider refinancing into a fixed-rate or a new adjustable rate mortgage. However, you’re still running the risk that interest rates will have increased at that point.

Adjustable-Rate Mortgage FAQs

Can I convert my ARM to a fixed-rate mortgage?

Let’s say you love what you thought would be your starter home and have decided you want to stay there indefinitely. If you have a convertible ARM, it contains a provision that grants you this option. However, if you are considering an ARM now, be aware that it will cost you more upfront, which may defeat the whole point of choosing the ARM to begin with.

With that said, even if your loan doesn’t contain a specific conversion clause, you can refi into a fixed-rate loan if you qualify.

My lender talks about basis points. What are they, and how do they relate to ARMs?

In real estate, the loan margin is often discussed in terms of basis points, which is the margin percentage multiplied by 100. For example, a real estate professional would likely refer to a 3% margin as 300 basis points above the benchmark.

Are there limits on how high ARM interest rates can go?

Conforming ARMs have lifetime rate caps that offer borrowers some predictability. These caps operate with respect to how often their interest rate changes, how much it can rise from period to period, as well as a total interest increase over the lifetime of the loan.

The Bottom Line

Whether to choose an adjustable-rate mortgage is just one consideration when purchasing a home. But it’s an important one. As you explore the types of mortgages, consider what makes the most sense for your unique situation.

Take the first step toward the right mortgage.

Apply online for expert recommendations with real interest rates and payments.

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Miranda Crace

The Rocket Mortgage Learning Center is dedicated to bringing you articles on home buying, loan types, mortgage basics and refinancing. We also offer calculators to determine home affordability, home equity, monthly mortgage payments and the benefit of refinancing. No matter where you are in the home buying and financing process, Rocket Mortgage has the articles and resources you can rely on.