Adjustable-rate mortgages: The pros and cons

How interest is calculated on your mortgage directly affects how much you’ll pay for your home. While most buyers choose a fixed-rate mortgage, an adjustable-rate mortgage, or ARM, is usually fixed at a slightly lower rate for a specific number of years and then adjusts depending on markets at specific intervals. This means your interest rate – and your monthly mortgage payment – will change. As with any type of mortgage, learning the pros and cons of an ARM will help you decide if it’s right for you and your financial goals. 

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.

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 than 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 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.

ARM pros

While interest rates and monthly payments do change with an ARM, there are benefits to this type of loan.

Lower introductory interest rates

ARMs typically have a lower introductory rate than a fixed-rate mortgage. The initial fixed-rate period ranges from 1 – 10 years. This lower rate results in lower monthly mortgage payments during the initial period. Lower introductory rates can benefit you if you plan on selling your home before your introductory rate expires or if you expect to earn more in the future.

Initial savings

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. The money you save in the introductory period can help you save enough to reduce the impact a later rate increase may have.

Interest rates could decrease

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 the limit set by your lender.

Rate caps

The degree to which your interest rate can increase will be limited by rate caps. This provides some protection if interest rates surge after you sign the loan. With Rocket Mortgage^®, your ARM rate can never go higher than 5% above your initial rate.

Ability to refinance

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.

ARM cons

There also are drawbacks to an ARM that are worth considering.

Interest rates could increase

After the initial fixed-rate period, the interest rate on an ARM can increase, raising your monthly payment. When taking on an ARM, it’s important to be prepared for a rate increase.

Less stability

ARMs are less predictable than fixed-rate loans. The uncertainty associated with changing interest rates can be challenging for borrowers. Budgeting and financial management may be more difficult, particularly for individuals with a fixed income or tight financial constraints.

It could cost more long-term

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.

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.

Adjustable-rate mortgage FAQs

Here are answers to common questions about adjustable-rate mortgages.

What happens after 5 years in a 5-year ARM?

Your interest rate on a 5-year ARM will adjust after 5 years of payments. This means your interest rate will increase or decrease based on current market rates, usually once per year.

Is an ARM loan ever a good idea?

Yes, an ARM loan can be a wise financial decision under specific circumstances. One winning scenario is if you plan on selling your home before your fixed-interest period ends. An ARM also may be a good idea if interest rates are expected to drop.

What are the risks of an ARM loan?

Risks include unpredictability, complex loan terms, and higher monthly payments.

The bottom line: Consider 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. 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.

If you’re interested in pursuing an ARM, get started with the approval process today.