What Is An Adjustable-Rate Mortgage (ARM) And How Does It Work?

Are you considering purchasing a home and wondering what an adjustable-rate mortgage (ARM) is and how it works? If you're looking for a loan option that offers an initial low interest rate, but with the potential to adjust in the future, an ARM might be just what you need. Here we will explore how ARMs work, the factors that influence their rates, and the pros and cons of choosing this type of loan. Whether you're a first-time homebuyer or considering refinancing, understanding the ins and outs of ARMs will empower you to make informed decisions about your mortgage.

What Is An Adjustable-Rate Mortgage (ARM)?

An adjustable-rate mortgage is a type of home loan that has an interest rate that fluctuates periodically throughout the life of the loan. Usually, when you secure an ARM, you'll enjoy a low introductory rate, often lower than what you would receive with a fixed-rate mortgage. This initial fixed period offers an appealing advantage for home buyers, as it translates to lower monthly payments and potential savings on interest compared to fixed-rate mortgages.

However, it's important to note that once the fixed period ends, the interest rate on an ARM will adjust based on market conditions. This means that the rate can either increase or decrease. While an ARM can offer financial benefits, it's crucial to carefully evaluate the potential impact of rising rates and payments on your budget before committing to this type of mortgage.

How Does An Adjustable-Rate Mortgage Work?

ARMs are long-term home loans with two periods: a fixed period and an adjustable period.

• Fixed period: During this initial, fixed-rate period (typically the first 5, 7 or 10 years of the loan), your interest rate won’t change.
• Adjustment period: This is when your interest rate can go up or down based on changes in the market.

Let’s say that you take out a 30-year ARM with a 5-year fixed period. That would mean a low, fixed rate for the first 5 years of the loan. After that, your rate could go up or down for the remaining 25 years of the loan.

Fixed Period Vs. Adjustment Periods

The fixed period refers to the initial phase of the loan when the interest rate remains stable, often at a lower rate than a fixed-rate mortgage. This period can range from a few months to several years, depending on the specific loan terms.

Once the fixed period ends, the adjustment period begins.

During this phase, the interest rate can change at predetermined intervals, such as annually or monthly, based on the type of ARM loan. For example, a 5/1 ARM has a fixed period of 5 years, after which the rate adjusts annually. Another example is a 7/6 ARM which has a fixed period of 7 years after which the rate adjusts every 6 months. Understanding the distinction between fixed and adjustment periods is crucial when considering an ARM.

• 5/6 ARM: A 5/6 mortgage has a fixed-rate period of 5 years with an adjustable rate that will fluctuate in accordance with the market every 6 months for the remainder of the loan’s term. With an annual adjustment period, you can map out your budget a year at a time. 5/6 ARMs are not available through Rocket Mortgage^®.
• 5/1 ARM: A 5/1 ARM has a fixed-rate period of five years. Once this initial fixed-rate period is up, your interest rate will adjust annually. However, your interest can’t go up indefinitely – a rate cap limits how much the interest rate can rise. The rate cap will vary depending on the loan you qualify for, but most rate caps are 5%. 5/1 ARMs are available through Rocket Mortgage^®.
• 7/6 ARM: The fixed period for a 7/6 loan is 7 years with a rate adjustment once every 6 months for the remaining life of the loan – in this case, your rate will adjust every 6 months for the remaining 23 years. With a longer fixed-rate period, you have some security built into your budget. 7/6 ARMs are available through Rocket Mortgage^®.
• 10/6 ARM: A 10/6 ARM has a fixed-rate period of 10 years. After that period, the adjustable rate will fluctuate every 6 months. A long fixed-rate timeline allows you to lock in a lower mortgage rate for an extended period of time. 10/6 ARMs are available through Rocket Mortgage^®.
• FHA ARM: Through the FHA, borrowers can tap into several hybrid ARM options with fixed-rate periods of 3, 5, 7 or 10 years. After the initial period, the interest rates adjust annually. When tapping into an FHA loan, you can typically make a smaller down payment and enjoy relatively lax credit requirements. FHA ARMs (5/1) are available through Rocket Mortgage^®.
• VA ARM: A VA ARM offers hybrid ARMs that come with a lower interest rate upfront. But after the fixed-rate period, the interest rate can increase or decrease. Like all VA home loans, this option is only available to eligible military service members and veterans. VA ARMs (5/1) are available through Rocket Mortgage^®.
• Jumbo ARM: A jumbo ARM allows the borrower to get a lower initial rate on a jumbo loan up to $3 million. Jumbo adjustable-rate mortgage loans are a great way to save a lot of money on interest during the initial lower-rate period. Often, especially on the larger loans, the savings can be in the multiple tens of thousands of dollars. Jumbo ARMs (7/6) are available through Rocket Mortgage^®.

Types Of ARM Loans

Adjustable-rate mortgages typically have a term of 30 years. The frequency of interest rate adjustments, whether monthly or yearly, can also differ among different types of ARMs. During the adjustment period, the monthly payment will change according to the current market interest rate. Let's take a closer look at some of the most common types of ARMs.

Hybrid ARM

A hybrid ARM behaves like a fixed-rate mortgage during an introductory period. Throughout this period, the interest rate will remain the same. After the introductory period expires, the interest rate will adjust on a predetermined schedule.

Interest-Only ARM

An interest-only ARM only allows interest payments for a set period of years. During that time, you’ll enjoy a lower monthly payment. But after the interest-only period is over, borrowers start paying back the principal in addition to interest, which means the mortgage payment increases.

Payment-Option ARM

A payment-option ARM provides borrowers the flexibility to select from a variety of payment options every month, such as making the minimum, paying just the interest, or covering both the  principal and interest. This adaptability is designed to cater to changing financial circumstances.

ARM Mortgage Rate Caps

ARMs have a set margin, which is the lowest the interest rate can go until the loan is paid in full. The following three rate caps limit how much the interest rate can fluctuate (up or down) over a specified period:

1. Initial: Immediately after the fixed rate ends.
2. Adjustment Period: Between each rate period.
3. Lifetime: Over 30 years.

On your loan paperwork, you’ll see your rate caps expressed as a series of numbers with slashes, such as 2/1/5 for example. This means your first adjustable rate can’t fluctuate more than 2% from your introductory rate, your rate can’t change more than 1% each adjustment period, and your rate can’t deviate more than 5% during the life of the mortgage.

ARM Mortgage Rates

Mortgage rates are influenced by a variety of factors. These include personal factors like your credit score and the broader impact of economic conditions. Initially, you may encounter an "initial rate" that’s much lower than the interest rate you’ll have at some point later on in the life of the loan.

The benchmark named in an ARM contract is the basis of an ARM’s rate. For example, the contract may name the U.S. Treasury or the secured overnight finance rate (SOFR) as a rate benchmark. Essentially, the benchmark will serve as the starting point of any reset calculations.

U.S. Treasury and SOFR rates are among the lowest rates possible for short-term loans to their most creditworthy borrowers; generally governments and large corporations. From that benchmark, other consumer loans are priced at a margin, or markup, to these cheapest possible loan rates.

The margin applied to your ARM depends on your credit score and credit history, as well as a standard margin that recognizes mortgages are inherently riskier than the types of loans indexed by the benchmarks. The most creditworthy borrowers will pay close to the standard margin on mortgages, and riskier loans will be further marked up from there.

The good news is that rate caps may be in place, indicating a maximum interest rate adjustment allowed during any particular period of the ARM. With that, you’ll have more manageable swings with each new rate change.

What Are The Advantages And Disadvantages Of Adjustable-Rate Mortgages?

ARMs offer unique benefits during the fixed period, but they also come with potential drawbacks during the adjustment period. Understanding both sides of the equation can help borrowers make informed decisions about their home financing. Let's explore the advantages and disadvantages of adjustable-rate mortgages.

Advantages

• ARMs can be very affordable during the fixed period, saving homeowners hundreds of dollars per month compared to other loan types.
• Due to the low fixed interest rates and low monthly payments during the initial period of an ARM, borrowers may qualify for a larger loan than with a different loan option.
• If interest rates fall, your monthly payments could drop even lower than before, and you won’t have to refinance to get those low rates.

Disadvantages

• Some borrowers may be put off by the unpredictability and instability of an ever-changing monthly mortgage payment throughout the adjustment period.
• Long-term ARMs will typically wind up costing more than a fixed-rate mortgage unless you sell or refinance before rates rise.
• Monthly payments can go up and become significantly more expensive than a fixed-rate mortgage.

Borrower Requirements For Adjustable-Rate Mortgages

As with all mortgages, ARM loans come with several requirements. You should be prepared to prove your income with W-2s, pay stubs and other documentation. Your income level will help the lender determine how large of a mortgage payment you qualify for.

Additionally, you’ll need a relatively good credit score to qualify. For example, most loans will require at least a 620 FICO^® Score.

Adjustable-Rate Mortgage FAQs

Let’s walk through some frequently asked questions about adjustable-rate mortgages.

What is an adjustable-rate mortgage vs. a fixed-rate mortgage?

An ARM may charge less interest during the introductory period, thus offering a lower initial monthly payment. But after that initial period, changing interest rates will impact your payments. If interest rates go down, ARMs can become less expensive. However, ARMs can also become more expensive if rates go up.

A fixed-rate mortgage offers more certainty because it retains the same interest rate for the life of the loan. That means your monthly mortgage payment will stay constant throughout the loan term.

Can you pay off an ARM early?

Yes, it is possible to pay off an adjustable-rate mortgage early. However, some ARMs may require you to pay early payment penalties, if you refinance or pay off it early, usually during the initial period (the first 3 to 5 years) of the loan. The specific terms and conditions regarding early repayment may vary depending on the lender and the terms of the loan agreement.

What is the advantage of refinancing an adjustable-rate mortgage to a fixed-rate mortgage?

Moving to a fixed-rate loan can help you get a more predictable monthly mortgage payment and keep you from having to worry about interest rates fluctuating year after year. However, you’ll want to review your financial circumstances to make sure refinancing is in your best interest.

When is an ARM a good idea?

An ARM could be a good choice if current interest rates are high. You can catch a break during the introductory period because your mortgage lender may have the chance to increase your rate later. Switching to an adjustable-rate mortgage could also be wise if you plan to move before the initial period ends or you plan to pay down your loan fast while the interest rate is low.

The Bottom Line

When it comes to purchasing a home, the decision of whether to choose an adjustable-rate mortgage is significant. It's crucial to consider your unique situation and what makes the most sense for your financial goals.

If you believe an ARM aligns with your house purchase plans and you're prepared to take the next steps in the home buying process, apply for initial approval today with Rocket Mortgage^®.