Adjustable-Rate Mortgage: The Pros And Cons To Consider
September 07, 2023 6-minute read
Author: Ashley Kilroy
With interest rates remaining higher than previous years and keeping some potential homebuyers out of the market, borrowers looking for answers are considering adjustable-rate mortgages (ARMs). These home loans offer flexibility in interest rates that adapt to market conditions. They also empower refinancing opportunities, cater to short-term homeownership plans, and enable investment property ventures. However, variable rates can counteract past savings and even create unaffordable mortgage payments. It’s important to know the nuances of ARMs to determine if one is right for you.
Adjustable-Rate Mortgage Overview
An adjustable-rate mortgage (ARM), also known as a variable-rate mortgage, is a type of home loan where the interest rate fluctuates over time based on changes in a specified financial index. The interest rate on an ARM is typically fixed for an initial period, usually ranging from 1 – 10 years, and then adjusts periodically based on market conditions.
Lenders determine an ARM's interest rate by adding a margin, which remains constant throughout the loan term, to the current value of the chosen market index. Commonly used indexes include the Secured Overnight Financing Rate (SOFR) and the U.S. Prime Rate. As the index value changes, the interest rate on the ARM will adjust accordingly, causing the monthly mortgage payment to increase or decrease.
In addition, lenders offer ARMs with cap structures to limit the rate adjustments. Specifically, the caps limit how far the interest rate can rise during the first adjustment, each subsequent adjustment, and over the loan term. For example, a 2/3/5 cap structure means the rate can rise no more than 2 points for the first adjustment. Then, the rate can’t rise more than 3 points per adjustment. Finally, the interest rate over the loan term can’t rise more than 5%.
In comparison, a fixed-rate mortgage is a loan where the interest rate remains constant throughout the entire term of the loan, providing borrowers with predictable and stable monthly payments. Your lender determines the interest rate on a fixed-rate mortgage during the loan origination, and it does not change over the life of the loan, regardless of any fluctuations in the market or the economy.
The primary difference between an adjustable-rate mortgage and a fixed-rate mortgage lies in the stability of the interest rate. With an ARM, the interest rate is subject to change, which means the monthly mortgage payment can increase or decrease over time. This dynamic presents uncertainty for borrowers because they may have trouble affording future payments.
In contrast, a fixed-rate mortgage offers the benefit of consistent payments throughout the loan term, allowing borrowers to plan their finances more effectively. The interest rate is locked in at the beginning, providing stability and protection against potential rate increases in the future. However, the initial interest rate on a fixed-rate mortgage is often higher than the starting rate of an ARM, reflecting the added security and predictability it offers.
When deciding between a fixed-rate mortgage and an adjustable-rate mortgage, borrowers need to consider their financial situation, risk tolerance and their plans for the future. For example, ARMs can benefit those who sell or refinance the property before the initial rate expires or those who experience decreasing interest rates. Fixed-rate mortgages are suitable for borrowers who prefer the security of a consistent payment and plan to stay in their homes for a more extended period.
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What Are The Pros And Cons Of An ARM?
Here are the advantages and disadvantages to consider for borrowers who want an ARM.
Lower Introductory Interest Rates
ARMs typically offer lower introductory interest rates than fixed-rate mortgages. During the initial fixed-rate period, which can range from 1 – 10 years, the interest rate on an ARM is typically lower than the prevailing rates for fixed-rate mortgages. This lower rate results in lower monthly mortgage payments during the initial period.
Lower Monthly Payments
Due to the lower introductory interest rates, ARMs provide borrowers with lower initial monthly payments than fixed-rate mortgages. This way, homeowners have freed-up funds for other expenses or savings.
Lower Interest Rates
Likewise, your ARM’s interest rate could remain low after the introductory period. For example, say your initial rate expires after 5 years. If market conditions drop interest rates below what you received when you first bought your home, your monthly payment lowers.
Ability To Pay Other Expenses
An ARM’s lower initial monthly payments allow borrowers to allocate their income toward other expenses or financial goals. This flexibility benefits individuals with competing financial priorities, such as paying off high-interest debts, saving for education or retirement or investing in home improvements. As a result, borrowers have more financial freedom to manage their financial situation.
Ability To Refinance
Another advantage of ARMs is the potential to refinance the loan before the introductory rate expires. Refinancing can enable borrowers to secure a fixed interest rate, providing them stability and predictable payments for the remainder of the loan term. As a result, borrowers who refinance their ARM can shield themselves from variable rate increases several years down the line.
Interest Rates Could Change
One drawback of ARMs is that the interest rates fluctuate over time. After the initial fixed-rate period, the interest rate on an ARM is adjusted periodically based on changes in the chosen financial index. Therefore, borrowers risk receiving rising interest rates. If market conditions or the index value increases, the interest rate on the ARM can also rise, potentially resulting in higher monthly mortgage payments.
Unlike fixed-rate mortgages, ARMs lack the stability of a constant interest rate throughout the loan term. The uncertainty associated with changing interest rates can create financial challenges for borrowers. Specifically, rising interest rates can inflate your future mortgage payments to the point of unaffordability. This drawback can make budgeting and financial management more difficult, particularly for individuals with fixed incomes or tight financial constraints.
The Monthly Payment Could Increase
One of the significant drawbacks of adjustable-rate mortgages is the potential for the monthly mortgage payment to increase. As the interest rate adjusts, the monthly payment changes accordingly. If the interest rate rises, borrowers may experience an unexpected and substantial increase in their monthly mortgage obligation. Depending on your loan balance, even a rate change of less than a percent can increase your monthly payment by one hundred dollars or more.
Is An Adjustable-Rate Mortgage Right For You?
An ARM can be a good option if you want to buy a home in specific situations. Here are some scenarios where an ARM may be suitable:
- Short-Term Homeownership Plans: An ARM is advantageous if you intend to stay in your new home for fewer years than the initial fixed-rate period of the ARM. For example, a 5/1 ARM means your rate will change in 5 years. If you plan to move out before the initial rate ends, you have 5 years or less to sell. For a 10/6 ARM, you have 10 years before the rate adjusts. By opting for an ARM, you’ll benefit from the lower introductory interest rates during the fixed-rate period, then sell the property or refinance the mortgage before the adjustable phase begins. This way, you can take advantage of the lower initial payments and avoid any potential interest rate increases in the future.
- Anticipated Income Increase: If you expect your income to increase significantly before the initial rate expires, an ARM can help you manage your monthly expenses until your income rises. However, it's essential to assess your financial situation and future income growth to ensure you can handle potential payment increases once the adjustable phase begins.
- Interest Rate Environment: An ARM can help when interest rates are currently high and expected to decline in the coming years. By initially securing a lower interest rate, borrowers take advantage of the savings during the fixed-rate period. Then, if interest rates drop, you can refinance into a lower fixed-rate mortgage or continue with the ARM if the adjustable rates remain favorable.
- Investment Property: Investors planning to sell the property before the fixed-rate period ends can benefit from lower initial interest rates and monthly payments. This way, you'll have more cash flow during the introductory period. In addition, you can sell the home before the initial rate expires to avoid the monthly payment jump.
The Bottom Line: Consider All Pros And Cons Of An ARM
ARMs offer lower introductory interest rates and initial monthly payments, benefiting borrowers with short-term homeownership plans, anticipated income increases or expectations of declining interest rates. ARMs also provide flexibility to allocate income towards other expenses and the ability to refinance before the introductory rate expires. However, the potential for interest rate changes, less stability and the possibility of increased monthly payments are drawbacks to consider. Ultimately, borrowers should carefully evaluate their financial situation, risk tolerance and future plans to determine if an ARM is the right choice for their needs. After contemplating these possibilities, you can learn more about getting approved for an adjustable-rate mortgage.
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