What Is An Adjustable-Rate Mortgage (ARM) Loan?

Homeownership marks the start of a new chapter in your life. But before you can move into the home of your dreams, you must decide which type of mortgage will work best for your financial goals. One available option is an adjustable-rate mortgage. But what is an adjustable-rate mortgage and how does it benefit future homeowners?

Adjustable-Rate Mortgage Definition

An adjustable-rate mortgage (ARM), also called a variable-rate mortgage or hybrid ARM, is a home loan with an interest rate that adjusts over time 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 typically lowest possible mortgage rate from the start.

The low initial interest rate won’t last forever, though. Once the initial period ends, your monthly payment can fluctuate periodically, resulting in unpredictable monthly mortgage payments that are harder to factor into your budget.

Taking time upfront to understand how ARM loans work can help prepare you if your rate starts to climb.

Adjustable-Mortgages Vs. Fixed-Rate Mortgages

Prospective home buyers can choose between an adjustable-rate mortgage and a fixed-rate mortgage. But what’s the difference between the two?

An ARM typically offers a lower, fixed interest rate during its introductory period than a fixed-rate mortgage, providing lower monthly mortgage payments at the start of the loan. After the initial period, changing interest rates will impact your monthly payment. When interest rates go down, ARMs can get cheaper. But if rates go up, ARMs can get more expensive.

A fixed-rate mortgage offers more certainty because the interest rate stays the same for the life of the loan. Your monthly interest and principal payment won’t change over the loan’s term.

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 initial, fixed-rate period, typically the first 5, 7 or 10 years of the loan, your interest rate won’t change.
• Adjustment period: This period comes after the fixed period. Your interest rate can go up or down based on changes with the benchmark index tied to the ARM (more on benchmark indexes soon). ARM mortgages have a 30-year term, so the adjustment period is always the difference between the fixed period from 30 years.

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.

How Are ARM Rates Determined?

Various factors influence ARM loan rates. They include personal factors, like your creditworthiness, which affects the margin the lender sets upfront, and economic factors, like the current benchmark rate tied to your loan and its rate caps. To calculate your mortgage rate, a lender adds the current benchmark rate to your margin.

Margins

The margin is a fixed percentage a lender adds to the current benchmark rate 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.

Benchmark Rates

The benchmark index specified in an adjustable-rate mortgage agreement is a key factor in determining an ARM’s rate and is the starting point for future interest rate adjustments.

For example, your ARM may be tied to a benchmark rate like the U.S. Treasury or the Secured Overnight Financing Rate (SOFR). Both are typically among the lower and more stable benchmark rates.

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 on your wallet.

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 5% more than your initial rate.

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. Non-Conforming ARM Loans

Beyond an ARM’s loan term, you’ll also need to decide between conforming loans and non-conforming loans as you explore your options.

Conforming ARM Loans

Conforming loans are mortgages that meet specific criteria that allow them to sell 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 (FHFA) – to Fannie and Freddie to resell to investors.

Loans that don’t meet these specific guidelines are non-conforming.

Non-Conforming ARM Loans

There are many reasons some borrowers choose a non-conforming 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. If you’re considering a non-conforming ARM, don’t sign on the dotted line until you’ve read the fine print on rate adjustments and caps.

Conventional Vs. 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).

If you use a government-backed loan, like an FHA ARM or a VA ARM, your mortgage is non-conforming 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 (VA loan, for example).

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.

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.

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.

Different Types Of ARM Loans

ARMs offer several loan structures to choose from. Here’s a closer look at your options:

5/1 And 5/6 ARMs

Both 5/1 and 5/6 ARM loans offer a fixed interest rate for the first 5 years of the loan term. The second number represents the frequency of future rate adjustments after the first 5 years. With a 5/1 ARM, the rate adjusts once a year for the remaining loan term. With a 5/6 ARM, the rate adjusts every 6 months.

7/1 And 7/6 ARMs

7/1 and 7/6 ARMs offer a fixed rate for 7 years. With a 30-year loan term, the initial fixed-rate period would last 7 years. Once the introductory period expires, you would make payments based on changing interest rates for the remaining 23 years on the loan.

Remember, interest rates rise and fall. You should prepare to cover a higher mortgage payment in your budget.

10/1 And 10/6 ARMs

10/1 and 10/6 ARMs have fixed rates for the first 10 years of the loan. After year 10, the interest rate will periodically fluctuate based on market conditions. A 30-year loan term means 20 years of changing payments.

Advantages Of An Adjustable-Rate Mortgage

Adjustable-rate mortgages can be the right move for borrowers who want to enjoy the relatively low rates many lenders offer for the initial period. With a lower upfront mortgage payment, you can:

• 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.
• 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.

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 Adjustable-Rate Mortgage

Like any mortgage type, an ARM has some potential downsides.

• Rates can go up: The biggest risk of an adjustable-rate mortgage 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.

Who Should Consider An ARM?

Typically, borrowers who crave certainty opt for fixed-rate mortgages.

However, an ARM might make more sense for some home buyers, particularly those who move a lot or are looking at starter homes. If you’re not buying a forever home, buying a house with an ARM and selling it before the fixed-rate period ends translates to lower mortgage payments upfront.

There’s always the risk that you won’t be able to sell the house before your rate adjusts. If you can’t sell, you may want to consider refinancing into a fixed-rate or new adjustable-rate mortgage. When refinancing, timing is critical. Unless you lock in your refinance rate, the interest rate on your original mortgage may increase before the terms of your refinance take effect.

How To Qualify For An ARM Loan

Like all mortgages, ARM loans have requirements borrowers must meet, such as proving their income with W-2s, pay stubs and other documentation. Your lender can use your income to help determine how large a mortgage you qualify for.

Requirements For An Adjustable-Rate Mortgage Loan?

Most ARM loans have requirements that are similar to fixed-rate mortgages. For a conventional loan, borrowers typically need a credit score of 620 or higher and a 3% down payment. For an FHA loan, you may qualify with a 580 credit score and a 3.5% down payment. VA loans allow qualifying with no down payment and a 580 credit score.

The Bottom Line

You’ll have plenty of serious decisions to make when buying a home, including whether to get an adjustable-rate or fixed-rate mortgage. Keep your finances, financial goals and future plans front of mind as you explore different types of mortgages.

If you believe an ARM is the right financing solution for your home purchase, you can start your approval for an ARM loan today.