As rates go up, more people are choosing adjustable rate mortgages. Here’s what you need to know.
By Juwan Rohan, Flyhomes Agent
With the average rate for 30-year fixed mortgages hovering around 6% in June, homebuyers are looking far and wide for other ways to afford their home loan. This search has led many to Adjustable Rate Mortgages (ARMs).
Until recently, it didn’t make much sense for the average homebuyer to use an ARM since rates on fixed rate loans were at historical lows. But according to Axios, almost 11% of all mortgages in the first half of June were ARMs, the highest since 2008.
After the US real estate bubble last popped in 2008, ARMs got a bad reputation. “ARMs got a bad name after 2008, because that’s where a lot of the predatory lending happened,” says Steve Grossman, VP of Flyhomes Mortgage. “We have new regulations to protect customers, and adjustable-rate loans can be a more affordable option for customers today.”
So an adjustable rate mortgage may be right for you. But there are a few different types, each with their own pros and cons. Here’s what to know about ARMs before you sign on the dotted line. In this article, we’ll look at Adjustable Rate Mortgages and lay out the pros and cons, so you can make an informed decision when it’s time to talk to a Flyhomes Mortgage loan officer.
Mortgage calculator: Estimate your monthly payment
All calculations are estimates and provided for informational purposes only. Actual amounts may vary.
What is an Adjustable Rate Mortgage?
When you apply for a mortgage, one decision you’ll have to make is between a fixed rate or an adjustable rate mortgage.
An ARM typically begins with an introductory fixed interest rate that is below the interest rate offered on fixed-rate mortgage loans. How long the ARM loan remains fixed during the introductory period depends on the specific ARM program and your lender. After the introductory fixed interest rate period, the interest rate may adjust up or down during the life of the loan as indexes and the market fluctuate.
How does an adjustable rate mortgage work?
Each ARM is different, so discuss the exact terms with your lender.
An ARM is divided into two main phases: your introductory fixed rate period and the following adjustable rate period. The length of time that your rate stays fixed and the frequency it adjusts afterward can change depending on the type of ARM you have.
The total term of an ARM is typically 30 years but options can include terms of 15 years, 20 years, or even 25 years.
“One of the more popular ARM products right now is the 5/6 Adjustable Rate Mortgage where your rate is fixed for five years, then may adjust every six months after that,” says Grossman.
But there are others out there for you to consider for different scenarios. Again, check with your lender to find out about the ARM programs they offer.
- The 5/6 ARM is fixed for five years and resets beginning at the sixth year and every six months afterward
- The 10/1 ARM is fixed for ten years and resets beginning with the eleventh year and every year afterward
- The 10/6 ARM is fixed for ten years and resets beginning with the eleventh year and every six months afterward
- The 7/6 ARM is fixed for seven years and resets beginning with the eighth year and every six months afterward
Which one you choose depends on the current ARM interest rates offered by your lender and your own financial situation. You may choose different ARMs depending on how long you think you will stay in the home, if you’re planning a large life event like a wedding or having a child, or if you need some extra time to afford a higher fixed-rate mortgage later.
“ARMs generally require that you do a little extra planning, predicting, and homework so you know you’re choosing the right one,” says Grossman. “But if you have a tolerance for a little more risk of higher payments in the future in exchange for lower payments today, it can be a very rational choice.”
Who is an ARM right for?
“It’s important to remember that an ARM is variable so it can also be unpredictable. These are best for people who will have the ability to adjust their budgets later, or think they will want to refinance or sell their house within that five to six year horizon,” says Grossman.
Those who know they will be moving out of the home or paying off the mortgage at some point during the fixed-rate period would benefit the most from an ARM, while taking advantage of the lower introductory interest rate for an ARM compared to a fixed-rate mortgage.
If you still have the mortgage when the rate changes, your payments are going to depend on the index used for your ARM, your ARM program, and your rate and payment caps, making it more of a gamble.
Lenders are required to provide advance notice of ARM adjustments that may impact your monthly payment.
Terms you need to know about adjustable rate mortgages
These terms will help you better understand the pros and cons of an adjustable rate mortgage.
- Adjustment Period The period between rate adjustments. This is usually stated in the name of the ARM. For instance, a 7/6 ARM will have a fixed-rate period of seven years and then beginning with the eighth year, the interest rate may adjust every six months thereafter.
- Fully Indexed Rate The Index plus the Margin equals the Fully Indexed Rate for your ARM loan. See more below.
- Index This is the number that will adjust over time. Common indexes are the US Treasury Bills, the US Prime Rate, and the Secured Overnight Funds Rate (SOFR). Changes in the index, along with your loan’s margin, determine the changes to the ARM interest rate at the time of the adjustment. An ARM adjustment can raise or lower your interest rate, depending on the movement of the index. Check with your lender to determine the index that will be used for your ARM loan.
- Margin The percentage amount that the lender will add to the index to determine your fully indexed rate. The fully indexed rate is the interest rate that will be considered at the time of an ARM adjustment and may impact your mortgage payment. Check with your lender to determine the margin that will apply for your ARM loan.
- Periodic adjustment cap The limit on how much the lender can raise your interest rate when the ARM is adjusted. For instance, if the index rises 4% but you have a 2% periodic adjustment cap, your interest rate will only go up 2%.
- Lifetime cap The limit on how much the interest rate can rise over the life of the ARM. For example, if you have a cap of 2% for each adjustment, a starting interest rate of 6%, and a lifetime cap of 6%, your interest rate can never be more than 12%. After applying the maximum interest rate adjustment of 2% for each adjustment period, after the third adjustment of 2%, your ARM loan will no longer adjust upward. Remember, the ARM loan can also decrease the interest rate depending on the movement of the index.
- Lifetime Floor Just as your ARM loan has a lifetime cap, it may also have a lifetime floor. Typically, the floor is the margin. If the margin is 2%, the floor (i.e., the lowest the interest rate can adjust depending on the movement of the index) is 2%.
Every ARM loan is different depending on the specific ARM program, the index, and margin that apply to the ARM loan. Be sure to check with your lender so you understand the index used, the margin that will apply to your ARM loan, the adjustment caps, the lifetime caps for interest, and floor.
What are the pros of ARMs?
Lower payments for a specified period
Because the introductory interest rate on an ARM is typically lower than the interest rate for 30-year fixed-rate mortgage loans at the time you get the mortgage (for example, in the US the week of June 16, 2022 rates on 5/1 ARM were 1.45% lower than rates on a 30-year fixed rate loan) your payments will likely be lower than if you had a fixed-rate mortgage. This could save you a significant amount of money, especially if you plan to sell the house before the introductory ARM fixed-rate period ends.
The potential for even lower payments
In the event that interest rates fall when the ARM rate adjusts, your payments could be even lower until the rate adjusts again. Because your payment could potentially be lower, this gives you a chance to pay down your principal faster. Some ARMs don’t allow their interest rates to go down, so make sure to ask your lender if this is possible.
Interest rate caps can give you some reassurance
If the ARM program for your loan offers interest rate caps, you may have some idea of how high your monthly payments could go, giving you reassurance that you’ll be able to make the payments down the road should your payments increase.
What are the cons of ARMs?
They can be confusing and unpredictable
A fixed-rate mortgage is pretty straightforward and the terms won’t change much depending on the loan program. If your interest rate is 5%, you know what your payments will be for the life of the loan and can plan accordingly. While the interest rate on a fixed-rate mortgage does not change, just remember that if you have an escrow account, the monthly escrow payment may change, which will impact your total monthly mortgage payment.
ARMs change due to a variety of factors, including the introductory fixed-rate period, adjustment frequency, interest rate caps, lifetime caps, and margin. With all these variables, ARMs can be confusing and unpredictable.
The monthly payment could change
If your ARM adjusts frequently, that means you’ll have to keep track of a monthly payment that also changes. Because there’s no way to know what interest rates are going to be in the future, this makes it difficult to plan for future mortgage payments and the impact on your budget.
You may end up with larger payments
If interest rates adjust upward, your payments may go up as well. And since you can’t predict what the index used for your ARM loan will do in the future, the rate could jump up more than you anticipated, leading to a larger payment than you had planned on. Your payment adjustment cap and lifetime adjustment cap will provide some security because you will know the highest the interest rate can adjust.
Some ARMs don’t adjust downward
In some cases, the interest rate for an ARM won’t adjust downward even if interest rates fall. It’s important to know if this is the case for your particular ARM. Ask your lender if there is a feature to adjust downward and, if so, what the floor will be.
Questions you should ask your lender when considering an ARM
- What is the initial introductory interest rate?
- How long is the initial introductory interest rate period?
- After the fixed-rate period, how often will the rate adjust?
- Is there an interest rate cap or payment cap?
- Can the rate adjust downward?
Weigh the pros and cons of an ARM
There’s a chance that rates could go down, lowering your payment even further. Or, they could go up, raising your payment. The CFPB’s Consumer Handbook on Adjustable Rate Mortgages says, “It’s a trade-off—you get a lower initial rate with an ARM in exchange for assuming more risk over the long run.”
At the end of the day, personal finance is just that: Personal. Weighing the pros and cons of different types of loans against your personal circumstances is the best way to make the best decision for you.
Disclosure: Flyhomes, Inc.: NMLS ID 1733272