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?
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.
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.
ARMs are long-term home loans with two periods: a fixed period and an adjustable period.
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.
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.
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.
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.
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:
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.