What Is An Adjustable-Rate Mortgage?

At the current average rate, you’ll pay $665.97 per month in principal and interest for every $100,000 you borrow. The average rate for a 15-year fixed mortgage is 6.29 percent, down 1 basis point from a week ago. At the conclusion of its latest meeting on Dec. 18, the Federal Reserve announced another quarter-point rate cut — the third cut in a row. Although the Fed has cut interest rates 100 basis points since September, mortgage rates have only risen, up 0.71 percentage points since September’s low, according to Bankrate data.

Pros and Cons of Adjustable-Rate Mortgages (ARMs)

That’s because you’re probably already getting the best deal available. Mortgage rates have decreased somewhat since earlier this year, with the 30-year fixed-rate loan down from a high of 7.39 percent in May. Monthly payments on a 5/1 ARM at 6.25 percent would cost about $616 for each $100,000 borrowed over the initial five years. While an ARM is one way to repay your home loan, it’s not always the best way for everyone. Make sure to weigh the pros and cons before choosing this option.

Advantages and Disadvantages of ARMs

There are certain features that might entice you to choose an ARM over a fixed-rate mortgage. There are benefits and drawbacks to consider before deciding if an adjustable-rate mortgage (ARM) is right for you. Yes, you can refinance your ARM to a fixed-rate loan as long as you qualify for the new mortgage. There are several moving parts to an adjustable-rate mortgage, which make calculating what your ARM rate will be down the road a little tricky. The interest rate on ARMs is determined by a fluctuating benchmark rate that usually reflects the general state of the economy and an additional fixed margin charged by the lender. Opting to pay the minimum amount or just the interest might sound appealing.

Adjustable period

When you get a mortgage, you’ll pay interest on the money you borrow. Your interest rate can be either fixed or adjustable — sometimes called variable. This booklet helps you understand important loan documents your lender gives you when you apply for an adjustable-rate mortgage (ARM). With nearly two decades in journalism, Dori Zinn has covered loans and other personal finance topics for the better part of her career. She loves helping people learn about money, whether that’s preparing for retirement, saving for college, crafting a budget or starting to invest. Her work has been featured in the New York Times, Wall Street Journal, CNN, Yahoo, TIME, AP, CNET, New York Post and more.

Payment uncertainty

If rates are up when your ARM adjusts, you’ll end up with a higher rate and a higher monthly payment, which could put a strain on your budget. If you’re in the market for a home loan, one option you might come across is an adjustable-rate mortgage. These mortgages come with fixed interest rates for an initial period, after which the rate moves up or down at regular intervals for the remainder of the loan’s term. Notably, some ARMs have payment caps that limit how much the monthly mortgage payment can increase in dollar terms. That can lead to a problem called negative amortization if your monthly payments aren’t sufficient to cover the interest rate that your lender is changing. With negative amortization, the amount that you owe can continue to increase even as you make the required monthly payments.

• Once the ARM’s fixed-rate period ends, changes happen periodically and what you pay one month could increase the next month.
• Occasionally the adjustment period is only six months, which means after the initial rate ends, your rate could change every six months.
• But because the rate changes with ARMs, you’ll have to keep juggling your budget with every rate change.
• Adjustable-rate mortgages, on the other hand, have fluctuating interest rates.
• Some adjustable-rate mortgage loans come with an early payoff penalty.
• ARMs come with rate caps that insulate you from possible steep year-to-year increases in monthly payments.
• However, it’s hard to budget when payments can fluctuate wildly, and you could end up in big financial trouble if interest rates spike, particularly if there are no caps in place.

Adjustable-Rate Mortgage: What an ARM Is and How It Works

After all, why wouldn’t you lock in an ultra-affordable rate and payment for the life of the loan? However, ARM loans often grow in popularity when rates are rising. That’s because ARM intro rates are typically lower than fixed rates. This can help borrowers lower their costs and the outset and potentially afford more expensive homes on the same budget. The caps on your adjustable-rate mortgage are the first line of defense against massive increases in your monthly payment during the adjustment period. They come in handy, especially when rates rise rapidly — as they have the past year.

Disadvantages of adjustable-rate mortgages

Keep in mind that if you cannot afford your payments, you risk losing your home to foreclosure. Once the ARM’s fixed-rate period ends, changes happen periodically and what you pay one month could increase the next month. These regular adjustments can be harder to predict and budget for, so an ARM may not be a good option if, for example, you have an unpredictable income or struggle with budgeting in general.

Where can you find an adjustable-rate mortgage?

They can help you navigate the complexities of mortgage options and make the best decision for your needs. When fixed-rate mortgage rates are high, lenders may start to recommend adjustable-rate mortgages (ARMs) as monthly-payment saving alternatives. Homebuyers typically choose ARMs to save money temporarily since the initial rates are usually lower than the rates on current fixed-rate mortgages.

• There are various features that come with these loans that you should be aware of before you sign your mortgage contracts, such as caps, indexes, and margins.
• In a volatile market, mortgage rates can rise swiftly and with little warning.
• The partial amortization schedule below shows how you pay the same monthly payment with a fixed-rate mortgage, but the amount that goes toward your principal and interest payment can change.
• If you persist with paying off little, then you’ll find your debt keeps growing, perhaps to unmanageable levels.
• Most ARMs feature low initial or “teaser” ARM rates that are fixed for a set period of time lasting three, five or seven years.
• Buying a home requires more than just saving up to get a mortgage and finding your perfect home.
• The initial borrowing costs of an ARM are fixed at a lower rate than what you’d be offered on a comparable fixed-rate mortgage.
• The 30-year mortgage, which offers the lowest monthly payment, is often a popular choice.

Benefits of a Fixed Rate Mortgage

• The best mortgage rate for you will depend on your financial situation.
• We’re transparent about how we are able to bring quality content, competitive rates, and useful tools to you by explaining how we make money.
• If your ARM follows the more popular hybrid model, you’ll pay the same low fixed interest rate for the first several years of your loan.
• The graphic below shows how rate caps would prevent your rate from doubling if your 3.5% start rate was ready to adjust in June 2023 on a $350,000 loan amount.
• A fixed-rate mortgage, on the other hand, has one set interest rate that doesn’t change for the life of your loan.
• As you explore your options, think about all the factors that could make an ARM ideal for your situation, or could make an ARM a challenge for you in the future.
• Eligible military borrowers have extra protection in the form of a cap on yearly rate increases of 1 percentage point for any VA ARM product that adjusts in less than five years.
• With a 7/1 ARM, you have a fixed rate for the first seven years of the loan.

This allows you to pay lower monthly payments until you decide to sell again. ARMs are also called variable-rate mortgages or floating mortgages. The interest rate for ARMs is reset based on a benchmark or index, plus an additional spread called an ARM margin. The primary benefit of a fixed-rate mortgage is the stability it offers.

What are ARM rate caps?

These caps limit the amount by which rates and payments can change. Interest rates are unpredictable, though in recent decades they’ve tended to trend up and down over multi-year cycles. During periods of higher rates, ARMs can help you save money in the early days of your loan by securing a lower initial rate. Just keep in mind that after the introductory period of the loan, the rate — and your monthly payment — might go up. The initial borrowing costs of an ARM are fixed at a lower rate than what you’d be offered on a comparable fixed-rate mortgage. But after that point, the interest rate that affects your monthly payments could move higher or lower, depending on the state of the economy and the general cost of borrowing.

Pros and Cons of Fixed-Rate Mortgages

For example, if you plan on only living in the home for around five years, you might feel comfortable taking on a 7/6 ARM, since the rate won’t adjust for seven years. Since ARMs can have lower payments at the start, they can offer more flexibility — at least toward the beginning of the mortgage. This could give you more cash to invest in other ventures or achieve other financial goals. The lender then applies a margin on top of that (it’s the lender’s profits). This is how it will come to your initial mortgage rate, which you’ll keep for the first few years of the loan.

What Is an Interest-Only Mortgage?

If you cannot afford your payments, you could lose your home to foreclosure. If rates decrease later, your monthly mortgage payment could go down. If rates start trending down in a few years, you could potentially have a lower rate than what you started with. An adjustable-rate mortgage has an interest rate that can change.

• The offers that appear on this site are from companies that compensate us.
• The table below is updated daily with current mortgage rates for the most common types of home loans.
• In this situation, you might want to consider giving yourself a bigger buffer, such as getting a 10/6 ARM.
• With a 7/1 ARM, you have a fixed rate for the first seven years of the loan.
• An adjustable-rate mortgage, or ARM, is a home loan that has an initial, low fixed-rate period of several years.
• The primary risk of ARMs is the potential for significant increases in monthly payments if interest rates rise.
• We’re transparent about how we are able to bring quality content, competitive rates, and useful tools to you by explaining how we make money.

However, the low introductory rate on an ARM could help lower your payment at the outset and boost your home-buying power. Usually, ARMs start off with a lower interest rate compared to fixed-rate mortgage rates but can increase (or decrease) over time. An interest-only mortgage is when you pay only the interest as your monthly payments for several years. A fixed-rate mortgage has an interest rate that remains unchanged throughout the loan’s term. (However, the proportion of the principal and interest will change).

Hybrid ARM

The average rate on a 5/1 adjustable rate mortgage is 6.25 percent, ticking up 4 basis points over the last week. Rates rose significantly in 2022, making an adjustable-rate mortgage a great option for many would-be homeowners and refinancers. If your plans are to settle in and plant roots for an extended period of time, or the uncertainty of an ARM is frightening, you may be better suited for a fixed-rate mortgage. The big difference between a fixed-rate mortgage (FRM) and an adjustable-rate mortgage (ARM) is that FRMs have a fixed interest rate and payment for the entire life of the loan. When you opt for an FRM, your rate and payment can never change unless you decide to refinance into a new mortgage loan.

Fixed-rate mortgages are the most popular choice for mortgage borrowers. The stable rate and payment make FRMs a safer option for homeowners because they never risk their payments rising and becoming unaffordable. The traditional 30-year fixed-rate mortgage is the most common type of home loan, followed by the 15-year fixed-rate mortgage. If you’ve ever seen a buying option like 5/1 or 7/1 ARM, that’s a hybrid adjustable-rate mortgage. For these types of loans, the interest rate is fixed for a set number of years—like three, five or seven, for example.

Is an Adjustable-Rate Mortgage Right For You?

But payments will balloon later on, and when this happens you will still have the full loan balance to pay off. Keep in mind that adjustable mortgage rate don’t always increase. If the index rate to which your loan is tied has fallen by the time your loan adjusts, your rate and payment also have to potential to go down. The initial period of an ARM where the interest rate remains the same typically ranges from one year to seven years. An ARM may make good financial sense if you only plan to live in your house for that amount of time or plan to pay off your mortgage early, before interest rates can rise. While there are rate caps in place to protect you, that doesn’t mean your rate and payment can’t increase significantly over time.

A fixed-rate mortgage comes with a fixed interest rate for the entirety of the loan. This means that you benefit from falling rates and also run the risk if rates increase. The term adjustable-rate mortgage (ARM) refers to a home loan with a variable interest rate. With an ARM, the initial interest rate is fixed for a period of time. After that, the interest rate applied on the outstanding balance resets periodically, at yearly or even monthly intervals.

They’re advantageous in certain situations, but compared to their fixed-rate counterparts, their unique interest rate structure can be difficult for some borrowers to understand. Eligible military borrowers have extra protection in the form of a cap on yearly rate increases of 1 percentage point for any VA ARM product that adjusts in less than five years. Previous attempts to introduce such loans in the 1970s were thwarted by Congress due to fears that they would leave borrowers with unmanageable mortgage payments.

One drawback is that fixed-rate mortgages often have higher initial interest rates compared to adjustable-rate mortgages. Additionally, if market interest rates decline, homeowners with fixed-rate mortgages will not benefit from the lower rates unless they refinance their loans. Bankrate follows a strict editorial policy, so you can trust that we’re putting your interests first.

There’s also the need to verify that your current finances can accommodate a higher payment down the road — even if you plan to move before the lower-rate period ends. It can be confusing to understand the different numbers detailed in your ARM paperwork. These mortgages can often be very complicated to understand, even for the most seasoned borrower.

This allows them to still afford the home they want without having to compromise due to higher rates. With a rate cap structure of 2/2/5, your rate could increase up to 5% at its first adjustment; as high as 7% at its second adjustment; and no higher than 8% over the entire life of the loan. The first number is how long the interest rate is fixed and the second number is how frequently that rate changes after the initial period. For instance, using our same example from above, a 5/1 ARM means the rate is fixed for five years and then variable every year after that. Based on the terms you agreed to with your mortgage lender, your payment could change from one month to the next, or you might not see a change for many months or even years.

Not every lender charges prepayment penalties, and the length of time for the penalty may vary. Before choosing an ARM, be sure to ask your lender if you would incur any penalties should you decide to pay your loan off early. The table below is updated daily with current mortgage rates for the most common types of home loans. Adjust the graph below to see historical mortgage rates tailored to your loan program, credit score, down payment and location. The 30-year mortgage, which offers the lowest monthly payment, is often a popular choice. However, the longer your mortgage term, the more you will pay in overall interest.

On top of that, the lender will also add its own fixed amount of interest to pay, which is known as the ARM margin. In many cases, ARMs come with rate caps that limit how much the rate can rise at any given time or in total. For example, if the index is 5% and the margin is 2%, the interest rate on the mortgage adjusts to 7%. However, if the index is at only 2%, the next time that the interest rate adjusts, the rate falls to 4% based on the loan’s 2% margin. ARMs may offer you flexibility, but they don’t provide you with any predictability as fixed-rate loans do.