What is an adjustable-rate mortgage and how do they work?

What is an adjustable-rate mortgage?

An ARM has variable interest rates over the life of the loan

You might hear an adjustable-rate mortgage referred to as a variable-rate mortgage because the interest rate changes over the life of the loan. The interest rate for an ARM stays fixed for a set amount of time, ranging from months to years, and then adjusts periodically at a predetermined frequency. The new interest rates might be lower or higher than the original interest rate and will affect the monthly mortgage payment.

Adjustable-rate mortgage vs. fixed-rate mortgage

Adjustable-rate mortgages are much more complex than fixed-rate mortgages. The interest rate on a fixed-rate mortgage stays the same for the entire life of the loan, whereas with an ARM, it adjusts.

While the interest rate on an ARM usually starts lower than current market interest rates, unlike with a fixed-rate mortgage, the rate will eventually change.

Why would you get an adjustable-rate mortgage?

Adjustable-rate mortgages remain one of the most used mortgage loan types. There are many reasons you might choose an ARM over a fixed-rate mortgage. Here are just a few:

• You can take advantage of lower-than-market introductory interest rates.
• ARMs can help build equity faster than other types of mortgages.
• There are now long initial fixed-rate terms that can last up to seven to 10 years.
• Many adjustable-rate mortgages offer rate and payment caps to protect from premium increases that will overwhelm the borrower.

Types of adjustable-rate mortgages

There are three main types of adjustable-rate mortgages.

Before you decide to use an adjustable-rate mortgage, it is important to understand the different types, what determines the interest rate and what ARM type would work best for your situation.

What are different types of adjustable-rate mortgages?

There are three main types of adjustable-rate mortgages.

1. Hybrid ARMs have a fixed-term interest rate for a period, followed by interest adjustments at set intervals after the initial fixed term ends. A hybrid ARM is shown in numerical values representing the initial fixed-rate term, followed by the schedule of how often the interest rate will reset. For example, a 5/1 ARM means that the loan will be at a fixed interest rate for the first five years and will adjust every year after.

2. Payment-option ARMs allow you to choose different payment options each month. For example, you can choose an interest-only payment to pay interest plus principal or to make a minimum payment that doesn't cover the interest. With the second option, you might end up with negative amortization, meaning the amount you owe goes up over time. This is the most risky type of ARM and has become a rare offering.

3. Interest-only ARMs have monthly payments only covering the interest rate for an introductory period. After a set term, usually ranging from a few months to a few years, the monthly payment will adjust so that you pay the mortgage off by the end of the loan term. This means you can expect a significant increase in monthly payments after the interest-only period ends.

What are adjustable-rate mortgages based on?

It can help to understand how the interest, payments and adjustment periods work.

These are some of the most common features to understand:

• Adjustment period: The adjustment period of an ARM is the time between rate changes. For example, a loan with rate adjustments each year would be a one-year ARM.
• Index and margin: The interest rate for an ARM is based on the index and margin. The index is calculated using market interest rates. The margin refers to extra interest points added by the lender after the fixed-rate period ends. Lenders calculate the margin, which is sometimes based on things like credit score, and it usually stays steady throughout the life of the mortgage.
• Caps: An interest cap on an ARM is a limit on the amount an interest rate can increase. There is an adjustment-rate cap limiting the increases during each adjustment period as well as a lifetime cap that limits how much the interest rate can rise over the life of the loan.

Some ARM loans also have a payment cap, limiting how much the monthly payment amount can be raised at each adjustment period.

How do you know which adjustable-rate mortgage is most beneficial for your financial situation?

If you decide to use an adjustable-rate mortgage, there are things to consider about your own financial situation to help you choose the right type of ARM, including your credit score, income and savings.

Adjustable-rate mortgages are generally easier to qualify for than fixed-rate mortgages. if your credit score isn't the best, or if your income is low now but expected to increase in the future, an ARM might work well for you. However, it's essential to consider whether you will be able to afford your monthly payments if the interest rate rises.

When considering an ARM you should also think about whether you plan to pay off the loan over a long or short period of time. For instance, if there’s a possibility you'll move in a few years, you may end up paying off the loan before the rates adjust, and it could be advantageous. If you plan to own your home for a long time, though, you will need to plan accordingly and be prepared for a rate increase.

Some people also choose an ARM if fixed rates are higher than average and they expect rates to decrease over time.

How adjustable-rate mortgages work

Adjustable-rate mortgages have an interest rate that is variable over time.

Learning how an ARM works and how the rates are calculated can help you decide if it's the right type of loan for you.

How do adjustable-rate mortgages work?

An adjustable-rate mortgage, like other types of mortgages, requires a monthly payment. However, with an ARM the monthly payment might fluctuate — unlike with a fixed-rate mortgage. This is due to possible interest rate changes.

Every mortgage has an amortization schedule. This is a schedule showing how much of the monthly payment is interest and how much is principal. In most cases, as the mortgage is paid off over time, the payments cover more of the principal amount on the loan. There are certain ARM loan options that can lead to negative amortization, like an interest-only or payment-option ARM — meaning the amount you owe goes up over time.

What mortgage rate can you get with your credit score?

While it is sometimes easier to qualify for an adjustable-rate mortgage, your credit score still affects your interest rate and payment. For instance, if you have a low credit score, the extra points added to the interest by the lender might be higher if your credit score is lower.

It's essential to price out several different ARMs through different lenders so you ensure you’re getting the most favorable rates. You can also monitor the overall interest rates in the mortgage industry.

Pros and cons of adjustable-rate mortgages

You might be able to gain more equity with an ARM.

Looking at the pros and cons of any type of mortgage is important when you’re weighing different options. Here are some pros and cons of adjustable-rate mortgages.

Pros:

• The introductory interest rate for an ARM is usually lower than market interest rates. This can be beneficial and help you build up equity faster, as more of your monthly payment goes to paying down the principal loan amount.
• Rates have the potential to go down over time, saving you money.
• If you do not plan to own your home for 30 years, a fixed-rate mortgage can cost more than an ARM. Many people who choose to use an ARM are not planning on living in their home long-term, or they know they will have funds to pay off the mortgage before the rate starts adjusting.
• You might be able to buy a more expensive home. Keep in mind the possibility that payments will rise over time.

Cons:

• While rates might go down, they might also go up. This means higher monthly payments and less money going toward paying down the principal loan balance.
• Negative amortization can occur if you have a payment-option ARM and you pay less than the amount needed to cover the interest.
• Unlike with a fixed-rate mortgage, the payments with an ARM fluctuate, which makes budgeting and planning for the future more complicated. Many people prefer the predictability of payments that comes with a fixed-rate mortgage.

Bottom line

Research different types of loans and lenders before making a decision.

An adjustable-rate mortgage might be right for you, depending on your circumstances. Remember to consider things like how long you plan to own your home and the affordability of future payments if they rise. It's also important to research other types of mortgage loans that might work and to get estimates from different mortgage lenders before making a final decision.