What are the pros and cons of ARM loans?

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An adjustable-rate mortgage (ARM) gives you impressive savings initially, especially if you're focused on keeping your monthly mortgage payment low for the first years of your loan. But it’s important to understand the long-term risks associated with it if interest rates rise. Basically, the pros and cons of ARM loans can best be boiled down to a simple tradeoff: lower upfront costs with future uncertainty.

There are ways to mitigate those risks, however, if you fully understand the advantages and disadvantages of ARMs compared to other types of mortgages. We’ll dive into all the details that will help you make the right decision for your current and future needs.

How do ARMs work?

An ARM is a home loan with an interest rate that is fixed for an initial period – usually 1 to 10 years – and then adjusts periodically based on market conditions. The total term of the loan is usually 30 years.

After the initial period ends, the new adjusting interest rate is calculated using an index plus a margin. The index reflects market conditions, while the margin is a fixed percentage that the lender sets. Your interest rate changes on a set schedule, known as the adjustment interval, such as every six months or every year.

ARMs tend to be more popular when overall interest rates are higher. That’s because borrowers get a lower initial interest rate on an ARM vs. a fixed-rate mortgage. Once the initial rate expires, your mortgage rate will adjust according to market conditions, which increases or decreases your monthly mortgage payment.

If you’re worried about the unpredictable nature of interest rates, that’s completely understandable. The good news is that ARMs generally come with caps that limit how much your interest rate can increase during the adjustment periods. There are three types of interest rate caps:

• Initial adjustment cap. This cap limits how much your interest rate can increase in the first adjustment after the fixed-rate period ends.
• Subsequent adjustment cap. This limits how much your interest rate can increase in each adjustment period after the initial adjustment.
• Lifetime adjustment cap. This limits how much your interest rate can increase in total over the life of the loan.

Cap thresholds vary depending on the lender you choose. Lenders also may have caps that limit how much your mortgage rate can go down over the life of the loan.

It’s important to know your interest rate floor, as well. This is the amount the rate is allowed to drop over the life of your loan.

ARM example

Let’s look at how a 5/1 ARM with a starting interest rate of 5.50% and adjustment caps of 2/2/5 works. In this loan, here’s what all the numbers mean:

• For the first five years of the loan, no matter what market rates do, your interest rate is set at 5.50%.
• After that, it can adjust once per year.
• Your rate can increase by up to 2% at the first adjustment. The exact amount will be calculated using the index plus a set margin.
• It can increase by up to 2% at each subsequent adjustment.
• It can never rise more than 5% above the original rate. In other words, the highest your rate can ever go is 10.50%.

Importantly, typically your monthly payment changes with your rate increase or decrease – yes, if rates drop, your rate drops with them after the initial five years of a fixed rate of 5.50%.

What are the pros of an ARM?

When the situation is right and ARMs are used wisely, the benefits can be substantial.

Lower introductory rates

One of the biggest advantages of an ARM is the savings in interest in the early, fixed-rate period of the loan. Though it changes with market conditions, an ARM’s initial rate can be nearly one percentage point lower than a 30-year, fixed-rate.

If you’re a buyer who plans to make extra principal payments, or you plan to sell or refinance your home before your fixed-rate period ends, the lower interest rate can translate into significant savings.

Lower initial monthly payments

ARMs provide borrowers with lower initial monthly payments than fixed-rate mortgages. This gives homeowners more room in their budget for other expenses or savings.

It can also make homeownership more affordable in the short-term.

For example, when you calculate the monthly payment on a $350,000 loan:

• At 5.50% (ARM), the payment will be approximately $1,987
• At 6.10% (fixed), the payment will be approximately $2,120

That difference adds up quickly and can improve buying power. It also means that you may qualify for a slightly higher-priced home or free up cash for other financial goals. You can see how your specific situation would play out by using Rocket Mortgage’s mortgage calculator.

Potential rate decreases

Your ARM’s interest rate could remain low or decline even more 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 will decrease.

Be sure to ask your lender what the interest rate floor is on your loan. Even if market rates decrease, your interest rate will never fall below this limit, which is set by your lender. And despite what people might claim, it’s not possible to predict market movements or future rates.

Protection through rate caps

The degree to which your interest rate can increase will be limited by rate caps. This is important protection. In times of rapid and large interest rate increases, the cap stops your rate from jumping too much in any given period. This helps you plan and adjust.

Let’s look at an example. Let’s say rates jumped by 3% during your ARM’s initial five years, when your rate was fixed at 5.50%. Now it’s time for the initial adjustment. The index aside, your rate could jump to 8.50%. But with a 2% cap, it can only go to 7.50%.

The lifetime cap is also vital. For instance, with Rocket Mortgage, your ARM rate can never go higher than 5% above your initial rate.

Flexibility to refinance¹

Another advantage of an ARM is the potential to refinance the loan before the introductory rate expires. Refinancing lets borrowers switch to a fixed interest rate and predictable payments. Borrowers who refinance their ARM can shield themselves from rate increases.

Just make sure you understand the cost of refinancing and plan to stay in your home long enough for it to pay off. A good start to calculating whether it makes sense for you is to use the Rocket Mortgage refinance calculator.

What are the cons of an ARM?

ARMs come with some potentially significant disadvantages, depending on your situation. Here are some you should consider.

Possible payment increases

Probably, the biggest downside of ARMs is the potential for rising payments. Once your initial fixed period ends, your interest rate could rise, meaning your monthly payment rises with it. Let’s look at an example:

Let’s use the earlier example, with a rate of 5.50% on a $350,000 loan. If the rate went up to 6.50%, the payment could increase by roughly $225 per month.

If your budget is already stretched to the limit, or you experience a job loss or reduction in income, the jump could result in missed mortgage payments. In the worst case, that could lead to foreclosure.

Greater financial uncertainty

ARMs bring a level of unpredictability to your mortgage that fixed-rate loans do not. You simply don’t know exactly what your monthly payment will be in the future. It’s the major trade-off for a lower initial rate and savings.

This could become a significant issue, making planning and budgeting tough. Even if you plan to refinance your loan or sell your home before your ARM adjusts, market conditions, credit issues, or job changes could make it more difficult.

All this means that ARMs are less suitable for buyers with fixed incomes or tight financial margins.

Potentially higher long-term costs

Despite the initial savings on an ARM, higher interest rates could make your loan significantly more expensive. You could end up paying much more interest than with a fixed-rate mortgage. Loan terms also may have obscure fees or penalties that result in higher long-term costs. Be sure to ask your lender how high your interest rates and monthly payments can go.

More complexity

ARMs are more complex when compared to fixed-rate mortgages. With an ARM, you need to understand how the index, margin, interest rate cap, and interest rate floor work before making decisions on whether a certain loan product is right for you.

This complexity makes prepaying an adjustable-rate mortgage work differently than a fixed-rate loan. With a fixed-rate mortgage, extra principal payments mainly eliminate payments at the end of your loan term. But with an ARM, the lender regularly recalculates your rate and payment based on the remaining balance. That means prepayments don’t significantly shorten the term. Instead, they reduce your balance, which leads to lower future payments and less interest over time.

Potentially harder qualification process

When you apply for an ARM, lenders typically evaluate whether you could afford a higher payment after the initial period ends. That means they may scrutinize your credit score, debt-to-income ratio, cash reserves, and down payment more closely. Ultimately, that could make mortgage qualification more difficult.

Is an ARM right for you?

When considering an ARM, the most important question is: Is it right for me? Consider some scenarios in which having an ARM might be beneficial to you, such as:

• You plan to own your home for a short time. An ARM can save you money if you sell your home before the initial fixed-rate period expires. You’ll benefit from the lower introductory interest rate and sell before your rate can adjust.
• You expect your income to increase. If you expect your income to increase significantly by the time your rate adjusts, an ARM can be an affordable way to buy a home now instead of later. Just make sure you’re prepared to handle payment increases when your rate adjusts. It also never hurts to have a backup plan to meet rising rates in case your projected income growth changes.
• You anticipate interest rates will fall. By securing a lower interest rate, home buyers 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 rates are favorable.
• You’re comfortable with the risk. If you believe you can handle higher payments in the future should rates rise, and that possibility doesn’t negatively impact your stress level, an ARM might be the right call.

Before you make a final decision about whether an ARM is the best fit for you, it’s wise to discuss your situation with a Rocket Mortgage Home Loan Expert or other home finance expert.

ARM alternatives to consider

If an ARM doesn’t align with your goals, there are other mortgage types worth considering. Here are some common ones people choose:

• A 15-year fixed-rate mortgage comes with higher monthly payments than a 30-year, fixed-rate loan but costs much less in interest over the life of the loan.
• A 30-year fixed-rate mortgage gives stable, predictable payments and makes long-term planning easier.

Government-backed loans, like FHA or VA loans, may offer lower down payment requirements and more flexible qualification criteria. These may be especially good if you qualify and are a first-time buyer.

FAQ

Here are some common questions borrowers have about ARMs.

What should I consider before choosing an ARM?

You should focus on your timeline, financial stability, and tolerance for risk. Also consider whether you could handle a higher monthly mortgage payment if rates increase, and finally, if you plan to sell or refinance before your fixed-rate period ends. Your goal is to get the best loan for your situation.

Why are ARMs popular in the current market?

ARMs are often more attractive when interest rates are high. The lower initial rates make homeownership more affordable in the short-term.

How can I get the lowest ARM rate?

Basically, the same way you get the best mortgage rates on any type of loan. An excellent credit score, low debt, and ample down payment, among other factors, help you get a better rate.

How do I apply for an ARM?

The process is like applying for any other mortgage type. You’ll have to provide financial documentation, have your credit checked, and work with a lender, who will evaluate your eligibility.

Can you convert an ARM to a fixed-rate mortgage later?

Yes, but it involves refinancing, which comes with costs and fees. This is a common strategy if you believe rates will rise after your initial fixed-rate period. There is also something called a convertible ARM. This gives you the option to convert your ARM into a fixed-rate mortgage after a certain amount of time. It also typically comes at a cost, however.

The bottom line: Weigh the pros and cons of an ARM

While ARMs come with real risks to consider, they can also help put you on the path to homeownership sooner. The main tradeoff of ARMs is they offer lower initial interest rates with the risk of increasing rates in the future.

If you’re comfortable with that risk, an ARM might be a good option. And if you plan to sell or refinance your home within the initial fixed-rate period, an ARM can make homeownership more affordable and save you a lot of money.

If you’re interested in pursuing an ARM or other type of home loan, you can reach out to Rocket Mortgage and get preapproved today.

¹ Refinancing may increase finance charges over the life of the loan.