Mortgage rates are still near historic lows, but they’ve been trending upward recently. If you’re looking for a better deal on your home financing – whether to buy a new home or to refinance a current one – an adjustable-rate mortgage (ARM) may be one solution. Here’s what you need to know about ARMs and how to decide if they’re right for your home financing needs.
What is an ARM?
An adjustable-rate mortgage or ARM is a home loan with an interest rate that can change according to certain terms. This sets it apart from the more-common fixed-rate mortgage, which has a rate that cannot change over the life of the loan.
An ARM typically consists of an intro period with a fixed intro rate followed by a series of adjustment periods with an adjusting rate. During the intro period, the intro rate cannot change, and after the intro period, the adjusting rate can change every time an adjustment period begins.
ARMs are available with various intro period lengths (such as 5, 7, 10 or even 15 years) and with various adjustment period lengths (such as 6 months or 1 year). For example, a 7/1 ARM would have an intro rate for 7 years, then an adjusting rate that would change every 1 year. A 10/6 ARM would have an intro rate for 10 years and an adjusting rate that would change every 6 months.
Whether and by how much an adjusting rate changes at the start of each adjustment period depends on the terms of the loan. Typically, the adjusting rate is based on an economic index and is limited by rate caps that control how high and how fast the rate can increase. These are the common rate caps:
- Initial cap: how much the rate can increase during the first adjustment period
- Periodic cap: how much the rate can increase during each following adjustment period
- Lifetime cap: how much the rate can increase in total from the intro rate
For example, the adjusting rate on an ARM with caps of 2/2/5 could not increase by more than 2 percentage points on the first adjusting year, 2 percentage points on each year thereafter and 5 percentage points total from the initial rate over the life of the loan.
The advantages of an ARM
The primary advantage of an ARM is that the intro rate is often lower than the lifetime rate of a comparable fixed-rate loan – such as 0.5 to 0.75 percentage points lower. A lower rate equates to a lower monthly principal and interest payment, meaning an ARM could potentially provide thousands of dollars in savings compared to a fixed-rate loan.
Here’s an example comparing the potential savings of a 10/6 ARM against a 30-year fixed-rate mortgage for the purchase of a $500,000 home with a 25% down payment.
30-Year Fixed | 10/6 ARM | |
Fixed-Rate Period | 30 years | 10 years |
Interest Rate | 3.750% | 3.825% APR | 3.000% | 3.069% APR |
Mortgage Payment | $1,737/month | $1,581/month |
In this example, the monthly payment for the ARM is about $156 month less than the 30-year fixed-rate loan, and over the first 10 years, the total savings would be approximately $18,720 – a very nice chunk of change indeed! And the bigger the rate difference or the bigger the loan amount, the bigger the savings would be.
The second notable advantage of an ARM is that it may be possible for the interest rate and monthly payment amount to drop during the future adjustment periods. Any drop will depend on the change in the index the ARM is tied to and may be subject to a rate “floor.” With a fixed-rate loan, the only way to obtain a lower rate is to refinance the loan, which can come with closing costs of several thousand dollars.
Important things to consider with an ARM
The major consideration with any ARM is the possibility that the monthly payment could increase during the adjustment periods. While this total potential increase is capped, it could still amount to a significant added cost depending on the amount of the increase and the strength of the borrower’s finances. Before someone obtains an ARM, their lender is required to show them the maximum dollar amount that their monthly payment could reach. The borrower should carefully consider whether they can afford this amount should they need to someday pay it.
However, many ARM borrowers never even reach the adjustment periods of their loans. That’s because the average homeowner keeps their loan for less than 10 years before either selling their home or refinancing their loan. With ARM intro periods available for 7, 10 or even 15 years, many ARM borrowers plan to simply ditch their ARMs before their intro periods end.
Selling or refinancing should not be relied on as a guaranteed way out of an ARM, however. A borrower who plans to refinance may not be able to get a new loan if their qualifications change (such as due to changes to their employment, income, debt or credit) or if mortgage requirements become stricter. A borrower who plans to sell may find that they end up staying in their home longer than they planned. These are possibilities that need to be considered.
Conclusion
While the predictability of a fixed-rate mortgage makes it the most popular type of home loan, borrowers who are seeking savings and are willing to accept some added risk may wish to consider an ARM strategy. Here are some situations in which an ARM may be appealing to you:
- You can obtain a significantly lower ARM intro rate than a fixed-rate mortgage rate
- You plan to sell your home or refinance your mortgage within 5 to 15 years
- You are willing to tolerate the risk that your mortgage payments may increase
At Draper and Kramer Mortgage, we’re happy to show you your current mortgage options and advise you on which solution is right for you. If you’re considering purchasing a home or refinancing a mortgage, please get in touch for a free mortgage consultation.
APR = annual percentage rate. Principal and interest payments do not include taxes, insurance and other homeownership costs. Rates and payments presented here are used for example purposes only and are not quotes or offers for financing. Adjustable-rate mortgages (ARMs) are loans with interest rates that change once the initial fixed-rate period ends. After the initial fixed period, the rate will adjust and remain in effect for 6 or 12 months depending on the loan program selected, and the rate may adjust every 6 or 12 months thereafter. Borrowers considering an ARM should understand the maximum amount their monthly payment could increase. Programs included on this document are subject to approval based on individual program guidelines and borrower’s credit and underwriting approval. Contact your Draper and Kramer Mortgage Corp. professional for full program details.