An adjustable-rate mortgage, commonly called an ARM, offers an alternative to a traditional fixed-rate mortgage. Instead of keeping the same interest rate for the entire loan term, an ARM typically provides an initial fixed-rate period followed by a rate that can adjust over time.
An ARM can be useful in the right circumstances, but borrowers should understand how future adjustments could affect their payments before choosing one.
How Does an Adjustable-Rate Mortgage Work?
An ARM generally starts with an interest rate that remains unchanged for a specified period. After that initial period ends, the rate can adjust at predetermined intervals according to the terms of the mortgage.
You may see ARMs described as a 5/6m ARM or similar structure. With a 5/6m ARM, for example, the initial interest rate lasts five years and can then adjust every six months. Other ARM structures may use different initial periods and adjustment schedules.
What Determines Your ARM Rate After the Initial Period?
After the initial rate period, an ARM's interest rate is generally determined using an index plus a margin. The index changes with broader market conditions, while the margin is established by the lender and remains fixed according to the loan agreement.
The resulting rate is sometimes called the fully indexed rate. Your actual adjustment is also subject to the rate caps and other terms contained in your mortgage.
How Do ARM Rate Caps Protect Borrowers?
ARMs typically include limits on how much the interest rate can change. An initial adjustment cap limits the change at the first adjustment, a subsequent adjustment cap limits changes at later adjustments, and a lifetime cap limits how much the rate can increase over the life of the mortgage.
Caps provide important limits, but they do not prevent your payment from increasing. Before accepting an ARM, review your Loan Estimate and ask your lender to explain the maximum rate and payment permitted under the loan terms.
What Are the Potential Benefits of an ARM?
An ARM may initially offer a lower rate than a comparable fixed-rate mortgage, although this is not guaranteed. When it does, the lower initial rate can result in a lower principal and interest payment during the introductory period.
If the applicable index declines after the adjustable period begins, the mortgage rate may also decrease, subject to the loan's terms and limits. However, borrowers should not select an ARM based on the assumption that market rates will fall.
What Are the Risks of an Adjustable-Rate Mortgage?
The primary risk is uncertainty. When the adjustable period begins, your rate and payment may increase if the applicable index rises or if an introductory rate was below the fully indexed rate.
This can make long-term budgeting more difficult than with a fixed-rate mortgage. An ARM may also be more complicated because borrowers need to understand the index, margin, adjustment frequency, rate caps, and maximum potential payment.
Who Should Consider an Adjustable-Rate Mortgage?
An ARM may be worth comparing if you are financially comfortable with the possibility of a higher future payment and understand the loan's adjustment terms. Your expected time in the home may also be relevant when comparing an ARM with fixed-rate financing.
However, avoid choosing an ARM simply because you expect to sell or refinance before the first adjustment. Your plans can change, and future mortgage rates, property values, income, and refinance eligibility cannot be guaranteed.
Is an ARM Better Than a Fixed-Rate Mortgage?
Neither option is automatically better. A fixed-rate mortgage provides greater predictability because the interest rate remains unchanged for the loan term. An ARM introduces future rate uncertainty but may provide different pricing during its initial period.
Compare the initial rate, APR, monthly payment, adjustment schedule, index, margin, rate caps, closing costs, and maximum potential payment before deciding.
Choose an ARM With the Long Term in Mind
An adjustable-rate mortgage can be a useful financing option when its structure matches your finances and tolerance for future payment changes. The key is understanding both today's payment and what could happen after the initial fixed-rate period ends.
Loan Wolf Lending can help Florida homebuyers compare adjustable-rate and fixed-rate mortgage options and understand how each could fit their homebuying plans. Call 754-755-3075 to discuss your mortgage options.