Should You Consider an Adjustable Rate Mortgage?

As its name implies, an adjustable rate mortgage (ARM) is one in which the rate changes (adjusts) on a specified schedule after an initial “fixed” period.

An ARM is considered riskier than a fixed rate mortgage because your payment may change significantly. In exchange for taking this risk, you are rewarded with an initial rate that is significantly below market rates for 30-Year Fixed Rate Mortgages. The more frequent the rate adjustments through the life of the loan, the lower the initial rate. Even after the loan adjusts, new rates will typically be below rates being offered to new borrowers for the 30-Year Fixed Rate program. Obviously, it’s best to have an ARM when interest rates are predicted to fall (not rise) because in periods of rising interest rates, it is possible that you will ultimately pay much more for an ARM than for a 30-Year Fixed Rate Mortgage.

Although somewhat riskier than a fixed rate mortgage, an ARM may benefit you if you have certain needs or find yourself in certain circumstances. In other circumstances, you may be better off with a fixed rate or other type of mortgage. Examine your financial and life situation with the help of your loan officer or financial advisor.

An ARM can give a short-term “boost” to your finances

Having a low initial fixed rate can free up some money early in your loan term.

For the purpose of illustration, we’ll assume a one-year ARM. This is a 30-year loan in which the rate (and therefore your monthly payment) changes every 12 months on the anniversary of your loan.

We’ll assume a 30-year fixed rate with zero points and a rate of 7.625 percent compared to a one-year ARM with zero points and an initial rate of 5.625 percent.

On a $240,000 loan amount, the 30-year fixed rate would yield a monthly payment of $1,698.70. The one-year ARM would yield a monthly payment of $1,381.58. That’s a difference of $317 per month, or $3,800 over the next year.

What could you do with an extra $3,800 this year? Some borrowers find the extra money useful for paying off other credit or moving expenses, for landscaping the yard, remodeling the bathroom, and so on. Of course, you will want to stay away from incurring additional debt or improving your lifestyle to the point that you can’t afford the higher payment once your rate adjusts upward.

An ARM can allow you to qualify for “more house”

Obtaining an ARM can allow you to qualify for a higher loan amount and therefore a more valuable house.

Many people with exceptionally large mortgages get one-year ARMs and refinance them every year. The low rate allows them to buy a costlier home yet pay the lowest mortgage payment possible. The down side is that there are costs associated with refinancing. So before you use this option, look at all the costs and do the math yourself or ask for help from your loan officer.

An ARM could be beneficial depending on your future plans

What are the factors that could cause you to move or upgrade in the next few years? Why obtain a higher-rate 30-year fixed rate mortgage if a job transfer or twins is even close to likely? An ARM with a lower initial rate could be a better (and cheaper) way to go.

If you know that you are only planning on living in a property for a short period of time (1-10 years) then the benefits of getting an adjustable rate mortgage are enhanced. You can enjoy the interest and payment benefits with less of the risk. Ask your lender to help you crunch the numbers.

If you do plan to refinance or sell soon (and therefore pay off the loan), read the loan documents carefully. Some contracts stipulate a penalty for paying off the loan early.

What affects the amount of the adjustment?

The amount of the rate change (referred to as an Adjustment) is determined by a mathematical formula based on a particular index, the most common being the 1-Year U.S. Treasury Bill.

Your lender does not control the index so it is safe to assume that your adjustment will be fairly determined (although you should always verify your new rate by comparing with published numbers).

All adjustable rate mortgages have a lifetime rate cap (ceiling), which limits the amount the interest rate of the loan can increase over the life of your loan. Most adjustable rate mortgages also have a periodic rate cap, which limits the amount of rate increase for each adjustment.

What kinds of ARMs are available?

1-Year Adjustable Rate Mortgage

This is a 30-year loan in which the rate (and therefore your monthly payment) changes every 12 months on the anniversary of your loan. This loan is considered quite risky because your payment may change significantly from year to year.

3-Year Adjustable Rate Mortgage

This is a 30-year loan in which the rate (and therefore your monthly payment) changes every 3 years. This loan, while risky, is safer than the 1-Year Adjustable Rate Mortgage only because it does not adjust as frequently.

5-Year Adjustable Rate Mortgage

This is a 30-year loan in which the rate (and therefore your monthly payment) changes every 5 years. This loan is a nice compromise between shorter term Adjustable Rate Mortgages and Fixed Rate programs.

3/1 Adjustable Rate Mortgage

This 30-year loan offers a fixed interest rate for the first 3 years and then turns into a 1 Year Adjustable Rate Mortgage for the remaining 27 years of the loan.

5/1 Adjustable Rate Mortgage

This 30-year loan offers a fixed interest rate for the first 5 years and then turns into a 1 Year Adjustable Rate Mortgage for the remaining 25 years of the loan.

7/1 Adjustable Rate Mortgage

This 30-year loan offers a fixed interest rate for the first 7 years and then turns into a 1 Year Adjustable Rate Mortgage for the remaining 23 years of the loan.

10/1 Adjustable Rate Mortgage

This 30-year loan offers a fixed interest rate for the first 10 years and then turns into a 1-Year Adjustable Rate Mortgage for the remaining 20 years of the loan.

To learn more about mortgage terms check out our glossary.