An adjustable-rate mortgage, or ARM, is a home loan that starts with a low fixed-interest “teaser” rate for three to 10 years, followed by periodic rate adjustments. ARMs are different from fixed-rate mortgages, which keep the same interest rate for the life of the loan.
How does an adjustable-rate mortgage work?
With an adjustable-rate mortgage, your payments can increase or decrease with interest-rate changes, based on the terms of your individual loan and a benchmark interest rate index chosen by your lender. In some cases, choosing an ARM over a fixed-rate mortgage could be a solid financial decision, potentially saving you thousands of dollars. You should always ask your lender to explain ARM risks and exactly how much the payments could increase.
Some people believe fixed-rate mortgages are always the better choice. But ARMs can be an option for home buyers who know they will have the loan for only a few years, says Don Maxon, a certified financial planner in San Rafael, California.
ARMs can make sense for customers who know they will be relocating in the near future or they know they will be paying off the loan in a few years.
“ARMs can make sense for customers who know they will be relocating in the near future or they know they will be paying off the loan in a few years, maybe due to retirement or expected inheritance or other receipt of funds,” Maxon says.
The pros of an of adjustable-rate mortgage
Low payments in the fixed-rate phase
A hybrid ARM offers potential savings in the initial, fixed-rate period. Common ARM terms are 3/1, 5/1, 7/1 and 10/1. With a 5/1 ARM, for example, your introductory interest rate is locked in for five years before it can change. That gives you five years of predictable, low payments.
An ARM can be a good idea if your life is likely to change in the next few years — for instance, if you plan to move or sell the house. You can enjoy the ARM’s fixed-rate period and sell before it ends and the less-predictable adjustable phase starts.
Rate and payment caps
ARMs may have several types of caps, which limit the increases on your mortgage rate and the size of your payment. These include caps on how much the rate can change each time it adjusts and the total rate change over the loan’s lifetime.
Your payments could decrease
If interest rates fall, and drive down the index against which your ARM is benchmarked, there’s a possibility that your monthly payment could drop.
» MORE: See today’s 5/1 ARM rates
The cons of an adjustable-rate mortgage
Your payments could increase
If interest rates are rising, your payments could increase after the adjustable period begins; some borrowers might have trouble making the larger payments.
Things don’t go as planned
ARMs require borrowers to plan for when the interest rate starts changing and monthly payments may grow. Even with careful planning, though, you might be unable to sell or refinance when you want to. If you can’t make the payments after the fixed-rate phase of the loan, you could lose the home.
Some ARMs come with a prepayment penalty. This is a fee that can be charged if you sell or refinance the loan. If you plan on selling the home or refinancing within the first five years of the mortgage, you should choose a lender who offers a loan without this penalty.
ARMs are complex
ARMs can have complicated rules, fees and structures. These complexities can pose risks for borrowers who don’t fully understand what they’re getting into.