The pros and cons of an adjustable rate home loan
What is an adjustable rate mortgage?
Adjustable rate mortgages (commonly called ARMs) are the second most common type of mortgage used by Americans after fixed rate mortgages. An adjustable rate mortgage involves borrowing a sum of money secured by the value of your home and then paying it back over the 'term' of the loan, typically 30 years. Unlike their fixed rate cousins, however, the rates and monthly payments for an ARM are not fixed for the entire term; after an initial fixed period, rates and monthly payments are reset, and could rise substantially. To find the best rates in the market, check our table of mortgage rates (customizable to your situation) or get a quote from our network of pre-screened lenders.
How does an ARM loan work?
Each ARM has an initial rate, often called the 'note rate', that is used to calculate the monthly payments at the start of the loan. This rate, and your monthly payments, are fixed for an initial period - 3 years, 5 years, 7 years and 10 years are among the most common periods used, though other variations are possible and are seen in the market. After the fixed period is over, a new rate and new payments are calculated (more on that later). This new rate and payment then remains constant for a shorter time - typically 1 year - before being recalculated again. The rates and payments continue to reset periodically until the end of the mortgage term. When you look for mortgage rates you may see products such as 3/1 ARMs and 5/1 ARMs listed. These names explain the frequency of rate and payment recalculation. For example, a 3/1 ARM is fixed for the first 3 year period and is then recalculated every 1 year afterwards. A 5/6 (or more properly 5/6-month) ARM is fixed for 5 years, and then mortgage rates and payments are recalculated every 6 months.
Once the fixed period is over, the new rate is calculated by adding together an 'index' - an interest rate set by governments or banks that is easy to look up - and a 'margin,' or a fixed amount over the index that provides for the lender's costs and profits. For example, many mortgages are calculated from the '12-month Wall Street Journal London Inter Bank Offer Rate' (often abbreviated to 12-month LIBOR, or just LIBOR), a value that can be looked up every day in the pages of the Wall Street Journal. A typical margin is 2.5%. For example, at the time of writing, LIBOR was at 0.77%. A mortgage with a margin of 2.5% resetting based on today's LIBOR rate would have an interest rate of 2.5% + 0.77%, or 3.27%.
What are the advantages of an adjustable-rate home loan?
While in the future the rate on an ARM loan may rise, in the short term these loans frequently come with significantly lower rates and payments than their fixed-rate brethren. For borrowers only planning to stay in a home for a period not much longer than the fixed period of the ARM, they can be a great choice. The shorter the fixed period, typically the lower the rate and initial payment.
What are the disadvantages of an adjustable-rate mortgage?
In a word, risk. Once the fixed period is over the rate and payment on your home loan can rise - often substantially. While ARM loans do come with built in protections, called caps, that limit how much the rate can increase after the fixed period is over, over the life of the loan these caps tend to be protections against catastrophic rate rises. For example, a typical lifetime interest rate cap may be 6% over the initial note rate, which will not prevent rates and payments from rising substantially. Also, if rates do rise, there is typically no good solution - while one can always refinance, any product you might choose to refinance into would also have a higher rate.
With those risks in mind, it is generally wise not to use an ARM unless you are fairly confident you will be out of your house within a year or two after the end of the fixed period.
3/1 or 10/1?
The trade off between different fixed period choices for your ARM is similar to the trade off between an Adjustable Rate Mortgage and a Fixed Rate Mortgage. Like choosing a 30-yr fixed instead of an ARM, choosing a longer fixed period (such as for a 10/1 ARM) leads to a longer period of certainty about rates, in exchange for higher rates and monthly payments. Shorter fixed periods such a 3/1, or even 1/1 ARMs may have significantly lower rates but come with much greater near-term uncertainty about rates and payments.
What do I do if rates fall?
With an adjustable-rate mortgage, if rates fall you don't need to do anything - once the fixed period of your ARM is over, you will find that rates and payments tend to fall with them. Be aware, however, that your rate can never be lower than the margin on your loan (see above for a discussion). To understand whether there is any benefit from refinancing your loan, ensure you know your current interest rate and use our 'Should I refinance?' calculator.
What do I do if rates rise?
If rates rise, unfortunately, there is little that you can do; once the fixed period of your ARM is over, your own rate and payment will rise (subject to a little protection provided by loan 'caps,' which are described above). Because it is likely that the rates on all new mortgages will have risen alongside your rate, it is unlikely that you will be able to find a new mortgage to refinance into that will come with a much better rate. This is the main drawback of ARMs. If you cannot afford to make payments higher than the starting, fixed rate, and are likely to be in the home for significantly longer than the fixed period, you may be best advised to consider a traditional fixed rate mortgage.