Adjustable-Rate Mortgage Guide How ARM Loans Work

On top of that, the lender will also add its own fixed amount of interest to pay, which is known as the ARM margin. In many cases, ARMs come with rate caps that limit how much the rate can rise at any given time or in total. For example, if the index is 5% and the margin is 2%, the interest rate on the mortgage adjusts to 7%. However, if the index is at only 2%, the next time that the interest rate adjusts, the rate falls to 4% based on the loan’s 2% margin. ARMs may offer you flexibility, but they don’t provide you with any predictability as fixed-rate loans do.

Can I switch from an ARM to a fixed-rate loan without refinancing?

Some ARMs have the potential to leave you in negative amortization, which means that even when you’re making payments, they’re not enough to cover the interest on your loan. This happens when your rate increases, taking your payment higher than your loan’s payment cap. After the fixed-rate period expires, your rate will start to adjust depending on where the index is at the time.

Where can you find an adjustable-rate mortgage?

The interest rate on an ARM adjusts periodically, typically once a year after the initial fixed-rate period. With an ARM, your rate stays the same for a certain number of years, called the “initial rate period,” then changes periodically. For example, if you have a 5/1 ARM, your introductory rate period is five years, and then your rate will go up or down every year. This means even if mortgage rates are on the rise and you’re set to get an increase, it won’t go up an exorbitant amount. Ask each lender to explain what kind of interest rate cap structure it uses for its ARMs as you shop around. Because ARM rates can potentially increase over time, it often only makes sense to get an ARM loan if you need a short-term way to free up monthly cash flow and you understand the pros and cons.

CFPB Report Finds Significant Drop in Annual Mortgage Applications and Originations in 2023

These caps limit the amount by which rates and payments can change. Interest rates are unpredictable, though in recent decades they’ve tended to trend up and down over multi-year cycles. During periods of higher rates, ARMs can help you save money in the early days of your loan by securing a lower initial rate. Just keep in mind that after the introductory period of the loan, the rate — and your monthly payment — might go up. The initial borrowing costs of an ARM are fixed at a lower rate than what you’d be offered on a comparable fixed-rate mortgage. But after that point, the interest rate that affects your monthly payments could move higher or lower, depending on the state of the economy and the general cost of borrowing.

Payment uncertainty

• If you’re confident you’ll be moving before the fixed-rate period ends, an ARM could be a great choice.
• However, the deterioration of the thrift industry later that decade prompted authorities to reconsider their initial resistance and become more flexible.
• If you cannot afford your payments, you could lose your home to foreclosure.
• This allows you to pay lower monthly payments until you decide to sell again.

Shorter-term mortgages offer a lower interest rate, which allows for a larger amount of principal repaid with each mortgage payment. So, shorter term mortgages usually cost significantly less in interest. In a fixed-rate mortgage, the interest rate is set at the beginning of the loan and does not fluctuate with market conditions. This fixed rate is typically determined based on the borrower’s creditworthiness, the loan term, and prevailing market rates at the time of origination.

Can I refinance an ARM to a fixed-rate mortgage?

• Bankrate follows a stricteditorial policy, so you can trust that our content is honest and accurate.
• An adjustable-rate mortgage is a home loan with a variable interest rate.
• You may need a score of 640 for a conventional ARM, compared to 620 for fixed-rate loans.
• This time a month ago, the average rate on a jumbo mortgage was lower at 6.87 percent.
• If you keep the same loan with the same lender, your mortgage payment won’t change.
• A payment-option ARM is, as the name implies, an ARM with several payment options.

A fixed-rate mortgage is a type of home loan where the interest rate remains constant throughout the entire term of the loan. This means that the monthly payments for principal and interest will not change, providing stability and predictability for homeowners. If you’re confident you’ll be moving before the fixed-rate period ends, an ARM could be a great choice. You’ll enjoy the perks of a cheaper introductory rate and payment, and then move before your low rate expires. If your plans change and you no longer plan to move, refinancing to a fixed-rate mortgage could be a viable option.

ARM caps in action

A mortgage calculator can show you the impact of different rates and terms on your monthly payment. An ARM has a variable interest rate, while a fixed-rate mortgage has a constant rate for the entire loan term. With a 7/1 ARM, you have a fixed rate for the first seven years of the loan. Then, your rate adjusts annually for the remainder of your loan’s term. A 5/1 ARM means your rate is fixed for the first five years of the loan. After that point, your rate adjusts once per year for the rest of your loan term.

Cons of an ARM

Lower initial payments can help you more easily qualify for a loan. ARM rates are often (but not always) lower than 30-year fixed rates. This means that while you’re in the fixed-rate period of your ARM, what is adjustable rate mortgage you could have a lower monthly payment, giving you more space in your budget for other necessities. ARMs generally have lower interest rates, at least initially, compared to fixed-rate mortgages.

What is an adjustable-rate mortgage?

There are certain features that might entice you to choose an ARM over a fixed-rate mortgage. There are benefits and drawbacks to consider before deciding if an adjustable-rate mortgage (ARM) is right for you. Yes, you can refinance your ARM to a fixed-rate loan as long as you qualify for the new mortgage. There are several moving parts to an adjustable-rate mortgage, which make calculating what your ARM rate will be down the road a little tricky. The interest rate on ARMs is determined by a fluctuating benchmark rate that usually reflects the general state of the economy and an additional fixed margin charged by the lender. Opting to pay the minimum amount or just the interest might sound appealing.

Interest-only ARM

But payments will balloon later on, and when this happens you will still have the full loan balance to pay off. Keep in mind that adjustable mortgage rate don’t always increase. If the index rate to which your loan is tied has fallen by the time your loan adjusts, your rate and payment also have to potential to go down. The initial period of an ARM where the interest rate remains the same typically ranges from one year to seven years. An ARM may make good financial sense if you only plan to live in your house for that amount of time or plan to pay off your mortgage early, before interest rates can rise. While there are rate caps in place to protect you, that doesn’t mean your rate and payment can’t increase significantly over time.

Fixed and adjustable-rate mortgages choosing depends on your financial goals and risk tolerance. Fixed-rate mortgages offer stable interest rates and predictable monthly payments, ideal for long-term planning and security. Adjustable-rate mortgages (ARMs), on the other hand, start with lower initial interest rates, which can adjust periodically based on market conditions.

Advantages and Disadvantages of ARMs

Choosing between fixed and adjustable-rate mortgages depends on your financial goals, risk tolerance, and market conditions. Fixed-rate mortgages offer stability and predictability, while ARMs provide lower initial payments and potential savings. Consulting with a financial advisor or mortgage specialist can provide personalized guidance tailored to your specific financial situation and goals.

Rates will depend on your mortgage lender, but in general, lenders reward a shorter initial rate period with a lower intro rate. Whether an adjustable-rate mortgage is the right choice for you depends on how long you plan to stay in the home, rate trends, your monthly budget, and your level of risk tolerance. Some of the most common terms are 5/1, 7/1, and 10/1 ARMs, but many lenders offer shorter or longer intro periods. Some ARMs, such as 5/6 or 7/6 ARMs, adjust every six months rather than once per year. This is usually a few years —  anywhere from three to 10 — and your rate and payment will stay the same for that entire period.

How much does 1 point lower your interest rate?

Then, the rate adjusts every year after that, which is what the second number indicates. One of the major cons of ARMs is that the interest rate will change. This means that if market conditions lead to a rate hike, you’ll end up spending more on your monthly mortgage payment. ARMs are great for people who want to finance a short-term purchase, such as a starter home. Or you may want to borrow using an ARM to finance the purchase of a home that you intend to flip.

What is a mortgage rate?

This can make it hard to budget and plan for and could strain your finances. If you check the respective index and see trends are going up or down, you’ll have a good idea whether your rate will increase or decrease at the next adjustment point. Your lender will also have rate caps in place that will determine how much your rate can increase each period and how high your rate can go over the life of your loan. With these options, you’ll pay the same rate for the first five or seven years of the loan. The first number, five, is how long the fixed interest term will last on your loan. This means you’ll pay the same interest rate for the first five years of your loan.

• One drawback is that fixed-rate mortgages often have higher initial interest rates compared to adjustable-rate mortgages.
• We’re the Consumer Financial Protection Bureau (CFPB), a U.S. government agency that makes sure banks, lenders, and other financial companies treat you fairly.
• Then, the interest rate may increase or decrease based on market rates.
• On top of that, the lender will also add its own fixed amount of interest to pay, which is known as the ARM margin.
• So, whether you’re reading an article or a review, you can trust that you’re getting credible and dependable information.
• Bankrate follows a strict editorial policy, so you can trust that we’re putting your interests first.
• Indeed, adjustable-rate mortgages went out of favor with many financial planners after the subprime mortgage meltdown of 2008, which ushered in an era of foreclosures and short sales.
• This predictability is especially valuable in times of economic uncertainty.

If broader interest rates decline, the interest rate on a fixed-rate mortgage will not decline. If you want to take advantage of lower interest rates, you would have to refinance your mortgage, which will entail closing costs. Before getting an ARM, you should also get an idea of where rates might head in the coming years.

FAQ about adjustable-rate mortgages

These loans, called tracker mortgages, have a base benchmark interest rate from the Bank of England or the European Central Bank. Learn more about 30-year mortgage rates, and compare to a variety of other loan types. At the current average rate, you’ll pay principal and interest of $664.63 for every $100,000 you borrow. Thirty-year mortgage rates tend to track the 10-year Treasury yield, which shifts continuously alongside the economy and the forces that shape it. More recently, rates have been driven by factors like inflation, the election and geopolitical developments abroad. Thanks to rising mortgage rates, affordability has taken a toll on many home buyers.

However, the deterioration of the thrift industry later that decade prompted authorities to reconsider their initial resistance and become more flexible. Lenders are required to put in writing all terms and conditions relating to the ARM in which you’re interested. A payment-option ARM is, as the name implies, an ARM with several payment options. These options typically include payments covering principal and interest, paying down just the interest, or paying a minimum amount that does not even cover the interest. With this type of loan, the interest rate will be fixed at the beginning and then begin to float at a predetermined time. The average 30-year fixed-refinance rate is 7.01 percent, down 4 basis points over the last week.

Fixed-rate mortgages and adjustable-rate mortgages (ARMs) are the two types of mortgages that have different interest rate structures. Fixed-rate mortgages have an interest rate that remains the same throughout the term of the mortgages, while ARMS have interest rates that can change based on broader market trends. Learn more about how fixed-rate mortgages compare to adjustable-rate mortgages, including the pros and cons of each. ARMs tend to be more popular with younger, higher-income households with bigger mortgages, according to the Federal Reserve Bank of St. Louis. Nearly 19 percent of households in the top income decile have ARMs compared with just 6.5 percent in the bottom income decile. The most common initial fixed-rate periods are three, five, seven and 10 years.

Borrowers with fixed-rate loans know what their payments will be throughout the life of the loan because the interest rate never changes. But because the rate changes with ARMs, you’ll have to keep juggling your budget with every rate change. In most cases, the first number indicates the length of time that the fixed rate is applied to the loan, while the second refers to the duration or adjustment frequency of the variable rate. The average rate for a jumbo mortgage is 7.02 percent, an increase of 7 basis points over the last week. This time a month ago, the average rate on a jumbo mortgage was lower at 6.87 percent. First, if you intend to live in the home only a short period of time, you may want to take advantage of the lower initial interest rates ARMs provide.

One drawback is that fixed-rate mortgages often have higher initial interest rates compared to adjustable-rate mortgages. Additionally, if market interest rates decline, homeowners with fixed-rate mortgages will not benefit from the lower rates unless they refinance their loans. Bankrate follows a strict editorial policy, so you can trust that we’re putting your interests first.

If your ARM follows the more popular hybrid model, you’ll pay the same low fixed interest rate for the first several years of your loan. This can save you a lot of money if you plan to only stay in your home for a few years and want to take advantage of the lower rate while you live there. Adjustable-rate mortgages, or ARMs, are an alternative choice to conventional mortgages.

After that initial period, the rate adjusts annually or according to the terms set by the lender, which might be more or less frequent. Since the rate on a fixed-rate mortgage doesn’t change, you won’t have to worry about your monthly payments changing. These adjustments are based on a market index—the Secured Overnight Financing Rate (SOFR) being the most common for adjustable-rate products—that your lender uses to set and follow rates. There are a few different indexes, and the benchmark index rate your lender chooses might be different from what another lender chooses.

• Traditional lenders offer fixed-rate mortgages for a variety of terms, the most common of which are 30, 20, and 15 years.
• This can make it hard to budget and plan for and could strain your finances.
• We are compensated in exchange for placement of sponsored products and services, or by you clicking on certain links posted on our site.
• Weight the pros and cons of a fixed vs. adjustable-rate mortgage, including their initial monthly payment amounts and their long-term interest.
• The fact that payments remain the same provides predictability, which makes budgeting easier.
• ARM loan guidelines require a 5% minimum down payment, compared to the 3% minimum for fixed-rate conventional loans.
• Conforming loans are those that meet the standards of government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac.
• A 5/5 ARM is a mortgage with an adjustable rate that adjusts every 5 years.

Conforming loans are those that meet the standards of government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. They are packaged and sold off on the secondary market to investors. Nonconforming loans, on the other hand, aren’t up to the standards of these entities and aren’t sold as investments. “For those expecting a dramatic drop in 30-year mortgage financing rates, 2025 is probably not the year,” says Ken Johnson, Walker Family chair of Real Estate for the University of Mississippi. “As expected, the Fed lowered rates again by 0.25 percent — it also lowered its expectations for rate cuts in 2025,” says Melissa Cohn, regional vice president of William Raveis Mortgage.

If you cannot afford your payments, you could lose your home to foreclosure. If rates decrease later, your monthly mortgage payment could go down. If rates start trending down in a few years, you could potentially have a lower rate than what you started with. An adjustable-rate mortgage has an interest rate that can change.

Our award-winning editors and reporters create honest and accurate content to help you make the right financial decisions. The interest rate and payment on an adjustable-rate mortgage can increase substantially over time. This is risky because it could make your mortgage payments unaffordable, especially if you have an unexpected financial change in the future like a job loss. If you’re in the military and find yourself relocating every 4 to 5 years, for example, the lower initial rate and payments on an ARM could be a better option than a fixed-rate mortgage. An ARM can also be a great option for first-time homebuyers who plan to start a family and upsize to a bigger home within five to 10 years. With an ARM, your monthly payment may change frequently over the life of the loan, and you cannot predict whether they will rise or decline, or by how much.

Fixed-rate mortgages are the most popular choice for mortgage borrowers. The stable rate and payment make FRMs a safer option for homeowners because they never risk their payments rising and becoming unaffordable. The traditional 30-year fixed-rate mortgage is the most common type of home loan, followed by the 15-year fixed-rate mortgage. If you’ve ever seen a buying option like 5/1 or 7/1 ARM, that’s a hybrid adjustable-rate mortgage. For these types of loans, the interest rate is fixed for a set number of years—like three, five or seven, for example.

Our editorial team receives no direct compensation from advertisers, and our content is thoroughly fact-checked to ensure accuracy. So, whether you’re reading an article or a review, you can trust that you’re getting credible and dependable information. In a volatile market, mortgage rates can rise swiftly and with little warning.