When you’re buying a home, you probably aren’t thinking much about how soon you’ll move out. But knowing if it’s possible you’ll move away, upgrade, or downsize within the next 10 years can be important when deciding on which type of mortgage is best for you.
That’s because certain mortgages, like an adjustable-rate mortgage, can help you save on interest in the early years of your loan, due to its low initial interest rates. Adjustable-rate mortgages can be risky, though, so read on to learn more about this option and if could be right for you.
What is an adjustable-rate mortgage?
As the name suggests, adjustable rate mortgages (ARMs) have interest rates that fluctuate. (That’s why ARMs are also known as variable rate mortgages.) Typically, the initial interest rate on an ARM will be fixed and lower than a comparable traditional mortgage. But that initial fixed-rate timeframe will be followed by an adjustable period during which the interest rate can fluctuate and will often rise.
In contrast, a fixed-rate mortgage has an interest rate that’s locked in for the life of the loan (usually 15, 20, or 30 years).
How do ARMs work?
With the most common type of ARM, the interest rate is fixed for a certain initial period — typically, five, seven, or 10 years — before it adjusts once a year based on whichever banking index the rate is tied to.
You may have seen these types of mortgages referred to as 5/1, 7/1, or 10/1 ARMs. The first number refers to the number of years the interest rate is fixed. The second digit can represent various things depending on your lender, but it may tell you how frequently the rate adjusts. (In this instance, once a year.) Having different options helps you find a mortgage loan that’s tailored to your financial situation.
How are the interest rates of an ARM determined?
After the fixed period, the interest rate of an ARM is reset each year based on a benchmark or index, plus an ARM margin, which is a fixed percentage. ARMs are generally tied to the LIBOR (London Interbank Offered Rate), which is the rate that banks charge each other for loans in London’s wholesale money market. This will continue to be the case until the end of 2021, at which point the benchmark will likely shift to the SOFR (Secured Overnight Financing Rate) with the discontinuation of LIBOR.
Until then, however, let’s say you are a borrower with a 7/1 adjustable rate mortgage. Your fixed rate is 3.4%. So, for the first seven years of the loan, your monthly mortgage and interest payments would remain the same. But at the beginning of the eighth year, your payments would reset. If the annual LIBOR for the preceding year were 2% and your ARM margin is +200 basis points, or 2%, your new interest rate would be 4% and your monthly payments would adjust accordingly.
Each subsequent year, your payments would again change, going up or down according to shifts in the LIBOR.
How high can the rate rise?
An important feature of ARMs protects you against skyrocketing interest rates. Most have caps that limit the total amount that your rate can increase, protecting you against sharp increases if and when you enter the adjustable period. Reviewing your loan documents can help you figure out whether it features an interest rate cap.
Several types of caps exist:
- Initial adjustment cap: limits the total increase during the first adjustment period (typically 2% for 5/1 ARMs and 5% for 7/1 or 10/1 ARMs).
- Subsequent adjustments cap: limits the increase in subsequent adjustment periods.
- Lifetime adjustment cap: establishes the maximum interest rate increase above your initial fixed rate. So, if your initial 5/1 ARM fixed rate was 3% and your lifetime adjustment cap is 5%, your interest rate can never go higher than 8%.
Why do ARMs decrease in popularity?
Historically, ARMs made sense for some homebuyers when interest rates were high. Their initial, smaller monthly mortgage payments made home ownership more affordable for first-time homebuyers, those who might otherwise have been priced out of the real estate market, and those wanting to purchase a more expensive home.
But this lending option has developed a poor reputation because ARMs are associated with higher rates of loan default and foreclosure. It’s really a matter of taking your finances, your needs, and your rate into account before deciding if an ARM could be the option for you.
ARM vs. Fixed-rate Mortgages
The main difference between ARMs and fixed-rate mortgages is that, as mentioned earlier, in a fixed-rate loan, the interest rate is locked in for the life of the loan. So, unless you choose to refinance your mortgage, that means your interest rate will stay the same for the loan’s entire term, whether it’s 15, 20, or 30 years. This might be a good option if you plan to make your house a forever home, or interest rates are low at the time.
Fixed-rate mortgages allow you to plan exactly how much you’ll pay each month throughout the life of your loan. On the other hand, while you can plan for the fixed period of your ARM, you may be responsible for larger (or smaller) payments once you reach the adjustable period of the loan. It’s important to know if you’ll be prepared for a higher monthly payment.
When taking out a mortgage, whether adjustable or fixed-rate, you may have to also get private mortgage insurance (PMI). PMI is an insurance policy for your lender that’s usually required if your loan-to-value is more than 80%. You can avoid having to pay these extra fees by making a down payment of at least 20%.
If you’re unable to make a 20% down payment, you might consider a first-time home buyer program, like a HomeReady mortgage or an FHA loan. These programs allow you to take out a mortgage with down payments as low as 3%.
Can you buy points on an ARM?
Some lenders allow you to buy points on your mortgage, which is basically paying interest on your loan in advance to reduce your interest rate. Typically, this means you pay the lender 1% of your mortgage upfront and, in exchange, lower your interest rate by .25%.
While you may be able to purchase points on an ARM, you’ll want to first consider if it’s worth the money. Lenders typically only apply the rate discount during the initial fixed-rate period. If your initial term is short — only three or five years — you might not break even. Meaning that buying points probably isn’t your best bet. But if your fixed term is seven or 10 years, it may make sense. You’ll just need to do the math.
When might an ARM make sense?
Despite their recent history, ARMs may make a lot of sense for some borrowers.
Perhaps you bought a house in a community where you are completing graduate school, a professional training program, or military service, but plan to move once you’ve completed the program. Or maybe you are expecting an increase in your earnings in the not-to-distant future and anticipate being able to afford a higher payment.
If you plan to sell your home within 10 years of purchasing it, you might consider an ARM loan. In these scenarios, you will benefit from lower monthly payments if you sell before your interest rate adjusts — meaning you’ll pay less total interest overall on the initial loan.
An ARM could make it possible for you to afford a more expensive home than otherwise would be possible, since you’ll have lower initial monthly payments.
The home-buying process can be full of lots of twists and turns. But we’re here to help you navigate them with confidence.
Ready to figure out which home loan fits your needs best?