To put it simply, an adjustable-rate mortgage (ARM) is a home loan option that offers a fixed rate for an initial set period. Once the introductory period ends, the rate is then adjusts periodically based on current market conditions until the next adjustment date.
While fixed-rate mortgages have long been the standard, ARMs are returning to the forefront in today’s high-rate environment. Because they often start with a lower interest rate than 30 year fixed loans, they can be a strategist tool for the right buyer.
ARM vs Fixed-Rate Mortgage: What’s the Difference?
An adjustable-rate mortgage has an interest rate that fluctuates throughout the loan term. The rate during the introductory is fixed until the adjustment period, where the rate changes based on the market. On the other hand, fixed-rate mortgage interest rates stay the same throughout the entire term of the loan.
| Feature | Adjustable-Rate (ARM) | Fixed-Rate Mortgage |
|---|---|---|
| Interest Rate | Changes over time after initial period. | Stays the same for the life of the loan. |
| Initial Payment | Typically lower than fixed-rate options. | Typically higher than an ARM’s intro rate. |
| Risk Level | Higher (payments can increase later). | Lower (predictable monthly payments). |
Common Types of Adjustable-Rate Mortgages
ARM names are usually expressed as two numbers (Example: 5/1). The first number is the length of the initial fixed-rate period. The second number is how often the rate adjusts after that.
5/5 ARM: Fixed for 5 years, then adjusts every 5 years.
3/1 ARM: Fixed for 3 years, then adjusts for every 1 year.
Other types of ARMs include: 5/1, 7/1 and 10/1 ARMs.
During the adjustment period your rate can either go up or down depending on the market at the time.
The Break-Even Math: Why Consider an ARM?
Many buyers choose an ARM for the short-term savings. For example, on a $400,000 loan, a 0.75% difference in rate could save you roughly $200 per month. Over a 5-year introductory period, that is $12,000 in total savings compared to a fixed-rate loan. If you plan to sell or refinance before those 5 years are up, that is money back in your pocket.
How is Your New Rate Determined? (The Index and Margin)
When the fixed rate period ends, your new rate is calculated using two components.
The Index: A benchmark interest rate set by neutral third parties based on the economy.
The Margin: A set percentage added by your lender that stays the same for the life of the loan.
Index + Margin = Your New Interest Rate
Rate Caps: Your Built-In Protection.
To prevent your payment from skyrocketing during your adjustment period, ARMs include interest rate caps. These limits dictate how much your rate can move.
Initial Cap: Limits how much the rate can rise the very first time it adjusts
Periodic (Annual) Cap: Limits how much the rate can change from one adjustment period to the next.
Lifetime Cap: Sets a ceiling for the maximum interest rate you will ever pay on the loan.
These protections can help ease some of the uncertainty that surrounds adjustable-rate mortgages.
Pros and Cons of an ARM
Pros:
- Lower Initial Payments: Save money during the first few years of homeownership
- Flexibility: Great for buyers who plan to move or refinance before the adjustment period
- Rate Drops: If the market rates decrease, your mortgage payment could actually go down without a refinance.
Cons:
- Market Volatility: Your payment could increase significantly after the introductory period.
- Complexity: ARMs are more difficult to understand and compare than fixed-rate loans.
Can you Refinance an ARM?
Absolutely. Most homeowners choose to refinance their ARM into a fixed-rate mortgage if they decide to stay in the home longer than expected or if interest rates drop significantly during their introductory period.
Who is an ARM Best For?
An ARM might be the right choice if:
- You plan to sell the home within 5 – 7 years.
- This is a starter home rather than a forever home.
- You expect a significant increase in your income before the adjustment period begins.
- You want to maximize your monthly cash flow in the short term.
Ready to Find the Right Mortgage?
Choosing between an ARM and a fixed-rate mortgage depends entirely on your financial goals and how long you plan to stay in your home.
Contact us today! Our experienced loan officers are ready to help you run the numbers and find the perfect loan to fit your needs.
Learn more about ARMs by visiting the U.S. Department of Housing and Urban Development’s website.
