Adjustable-Rate Mortgage Guide How ARM Loans Work

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.

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The second number (“1”) represents how often your interest rate could adjust up or down. Using the 5/1 ARM example, after your fixed rate expires, your interest rate could adjust up or down once each year. An interest-only (I-O) mortgage means you’ll only pay interest for a set amount of years before you get the chance to start paying down the principal balance. With a traditional fixed-rate mortgage, you’ll pay a portion of the principal and some of the interest every month but the total payment you make never changes. An ARM may also make sense if you expect to make more income in the future. If an ARM adjusts to a higher interest rate, a higher income could help you afford the higher monthly payments.

Should you get an adjustable-rate mortgage?

In most cases, the rate will stay the same for a set amount of time based on the lender and type of ARM you choose. This could mean the rate is the same for the first month or up to five years. For example, if you get a 5/1 ARM, your rate will remain fixed for the first five years and then will become variable for the rest of the term. A hybrid ARM is an adjustable rate mortgage that remains fixed for an initial period and then adjusts regularly thereafter. For example, a hybrid ARM may remain fixed for the first 5 years, and then adjust every year after that. 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.

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

If you are considering an ARM, calculate the payments for different scenarios to ensure you can still afford them up to the maximum cap. For instance, if you take out a 5/1 ARM with an index at 3% and a margin of 2%, your intro rate is 5%. Let’s say when the intro period ends, the index has dropped to 1.5% — your rate for the following year will be 3.5% (1.5% index + 2% margin). 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.

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For these averages, APRs and rates are based on no existing relationship or automatic payments. Monthly payments on a 15-year fixed mortgage at that rate will cost $860 per $100,000 borrowed. Our experts have been helping you master your money for over four decades.

How to get the best mortgage rate

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.

• An adjustable-rate mortgage (ARM) is a type of home loan that offers a low fixed rate for the first few years, after which your interest rate and payment can move up or down with the market.
• With a 5/1 ARM, you would have an introductory fixed-rate period of five years.
• You’ll have a fixed rate for the first decade, and then the rate changes once per year after that.
• A fixed-rate mortgage has an interest rate that remains unchanged throughout the loan’s term.
• We follow strict guidelines to ensure that our editorial content is not influenced by advertisers.
• At the conclusion of its latest meeting on Dec. 18, the Federal Reserve announced another quarter-point rate cut — the third cut in a row.
• With less purchasing power at higher fixed rates, the lower introductory rates attached to ARMs have started to look much more appealing.

Benefits of an ARM

• In most cases, the rate will stay the same for a set amount of time based on the lender and type of ARM you choose.
• With a rate cap structure of 2/2/5, your rate could increase up to 5% at its first adjustment; as high as 7% at its second adjustment; and no higher than 8% over the entire life of the loan.
• You may also want to consider applying the extra savings to your principal to build equity faster, with the idea that you’ll net more when you sell your home.
• The content created by our editorial staff is objective, factual, and not influenced by our advertisers.
• With a fixed-rate mortgage, monthly payments remain the same, although the amounts that go to pay interest or principal will change over time, according to the loan’s amortization schedule.

This can lead to lower payments in the short term but introduces the risk of rising payments in the future. Understanding the benefits and risks of each type will help you make an informed decision tailored to your financial situation and homeownership plans. Bankrate.com is an independent, advertising-supported publisher and comparison service. We are compensated in exchange for placement of sponsored products and services, or by you clicking on certain links posted on our site. While we strive to provide a wide range of offers, Bankrate does not include information about every financial or credit product or service. The best mortgage rate for you will depend on your financial situation.

How much is a mortgage point?

It also includes finding the right type of mortgage that’s best for your budget—loan term, interest rate and monthly payment all play a factor in what you can reasonably afford. An adjustable-rate mortgage (ARM) might be something to consider as you’re exploring different borrowing options. The monthly payments for shorter-term mortgages are higher so that the principal is repaid in a shorter time frame.

year mortgage refinance rate eases, -0.04%

You can use those extra funds to pay off other debt, invest in your future or make larger payments on your mortgage principal to pay off the loan faster. In the recent past, ARMs have charged as much as a full percentage point less than fixed mortgages. The increase is directly related to the rise in fixed mortgage rates, which were nearing 8 percent last fall, a level not seen since 2000. With less purchasing power at higher fixed rates, the lower introductory rates attached to ARMs have started to look much more appealing. However, if you’re going to stay in your home for decades, an ARM can be risky.

• The interest rate and payment on an adjustable-rate mortgage can increase substantially over time.
• An adjustable-rate mortgage, or ARM, is a home loan that has an initial, low fixed-rate period of several years.
• The offers that appear on this site are from companies that compensate us.
• With a traditional fixed-rate mortgage, you’ll pay a portion of the principal and some of the interest every month but the total payment you make never changes.
• The primary risk of ARMs is the potential for significant increases in monthly payments if interest rates rise.

Fixed-rate vs. adjustable-rate mortgages

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.

This is different from a fixed-rate mortgage, which locks in your rate for the entire life of your loan. For example, if you have a 30-year fixed-rate mortgage, you’d pay the same rate for all 30 years. The “limited” payment allowed you to pay less than the interest due each month — which meant the unpaid interest was added to the loan balance. When housing values took a nosedive, many homeowners ended up with underwater mortgages — loan balances higher than the value of their homes. The foreclosure wave that followed prompted the federal government to heavily restrict this type of ARM, and it’s rare to find one today. A payment-option ARM, however, could result in negative amortization, meaning the balance of your loan increases because you aren’t paying enough to cover interest.

How ARM rate caps work

Our mission is to provide readers with accurate and unbiased information, and we have editorial standards in place to ensure that happens. Our editors and reporters thoroughly fact-check editorial content to ensure the information you’re reading is accurate. We maintain a firewall between our advertisers and our editorial team. Our editorial team does not receive direct compensation from our advertisers. Adjustable-rate mortgages, on the other hand, have fluctuating interest rates.

A fixed-rate mortgage, on the other hand, has one set interest rate that doesn’t change for the life of your loan. This type of mortgage can be a more affordable means to get into a home, especially when higher rates on fixed mortgages are beginning to price some borrowers out. But is it worth the risk of unknown and potentially larger payments in the future? Here’s how to know if you should get an adjustable-rate mortgage. If interest rates in general fall, then homeowners with fixed-rate mortgages can refinance, paying off their old loan with one at a new, lower rate. The ARM index is often a benchmark rate such as the prime rate, the LIBOR, the Secured Overnight Financing Rate (SOFR), or the rate on short-term U.S.

That’s because you’re probably already getting the best deal available. Mortgage rates have decreased somewhat since earlier this year, with the 30-year fixed-rate loan down from a high of 7.39 percent in May. Monthly payments on a 5/1 ARM at 6.25 percent would cost about $616 for each $100,000 borrowed over the initial five years. While an ARM is one way to repay your home loan, it’s not always the best way for everyone. Make sure to weigh the pros and cons before choosing this option.

How Fixed Interest Rates Work

The average rate on a 5/1 adjustable rate mortgage is 6.25 percent, ticking up 4 basis points over the last week. Rates rose significantly in 2022, making an adjustable-rate mortgage a great option for many would-be homeowners and refinancers. If your plans are to settle in and plant roots for an extended period of time, or the uncertainty of an ARM is frightening, you may be better suited for a fixed-rate mortgage. The big difference between a fixed-rate mortgage (FRM) and an adjustable-rate mortgage (ARM) is that FRMs have a fixed interest rate and payment for the entire life of the loan. When you opt for an FRM, your rate and payment can never change unless you decide to refinance into a new mortgage loan.

Is an adjustable-rate mortgage right for you?

At the current average rate, you’ll pay $665.97 per month in principal and interest for every $100,000 you borrow. The average rate for a 15-year fixed mortgage is 6.29 percent, down 1 basis point from a week ago. At the conclusion of its latest meeting on Dec. 18, the Federal Reserve announced another quarter-point rate cut — the third cut in a row. Although the Fed has cut interest rates 100 basis points since September, mortgage rates have only risen, up 0.71 percentage points since September’s low, according to Bankrate data.

• An adjustable-rate mortgage is a great tool for many home buyers, but it also comes with serious risks that borrowers need to be prepared for.
• When you get a mortgage, you can choose a fixed interest rate or one that changes.
• In a fixed-rate mortgage, the interest rate is set at the beginning of the loan and does not fluctuate with market conditions.
• However, the longer your mortgage term, the more you will pay in overall interest.
• You’ll enjoy the perks of a cheaper introductory rate and payment, and then move before your low rate expires.

Bankrate follows a stricteditorial policy, so you can trust that our content is honest and accurate. The content created by our editorial staff is objective, factual, and not influenced by our advertisers. An adjustable-rate mortgage (ARM) is a type of home loan that offers a low fixed rate for the first few years, after which your interest rate and payment can move up or down with the market. With an I-O home loan, you’ll have smaller monthly payments that increase over time as you eventually start to pay down the principal balance. The longer your I-O period, the larger your monthly payments will be after the I-O period ends. With a fixed-rate loan, you’ll pay one set amount every month for the duration of your loan term, like 15, 20 or 30 years.

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.

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.

However, the low introductory rate on an ARM could help lower your payment at the outset and boost your home-buying power. Usually, ARMs start off with a lower interest rate compared to fixed-rate mortgage rates but can increase (or decrease) over time. An interest-only mortgage is when you pay only the interest as your monthly payments for several years. A fixed-rate mortgage has an interest rate that remains unchanged throughout the loan’s term. (However, the proportion of the principal and interest will change).

For example, if you plan on only living in the home for around five years, you might feel comfortable taking on a 7/6 ARM, since the rate won’t adjust for seven years. Since ARMs can have lower payments at the start, they can offer more flexibility — at least toward the beginning of the mortgage. This could give you more cash to invest in other ventures or achieve other financial goals. The lender then applies a margin on top of that (it’s the lender’s profits). This is how it will come to your initial mortgage rate, which you’ll keep for the first few years of the loan.

If the balance rises too much, your lender might recast the loan and require you to make much larger, and potentially unaffordable, payments. For example, a 2/28 ARM features a fixed rate for two years followed by a floating rate for the remaining 28 years. In comparison, a 5/1 ARM has a fixed rate for the first five years, followed by a variable rate that adjusts every year (as indicated by the number one after the slash). Likewise, a 5/5 ARM would start with a fixed rate for five years and then adjust every five years.

It’s possible for your ARM rate to go down if interest rates fall and then your rate adjusts. ARM rates are much more likely to increase when they adjust than to decrease. An adjustable-rate mortgage is a great tool for many home buyers, but it also comes with serious risks that borrowers need to be prepared for. It can be, especially if they plan to sell or refinance before the initial fixed-rate period ends. Rate caps limit how much the interest rate can increase at each adjustment period and over the life of the loan.

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 adjustable rate mortgage rates 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.

If you keep the same loan with the same lender, your mortgage payment won’t change. An ARM, sometimes called a variable-rate mortgage, is a mortgage with an interest rate that changes or fluctuates during your loan term. Other loans typically have a fixed rate, where the interest rate doesn’t change over the life of the loan.

They’re advantageous in certain situations, but compared to their fixed-rate counterparts, their unique interest rate structure can be difficult for some borrowers to understand. Eligible military borrowers have extra protection in the form of a cap on yearly rate increases of 1 percentage point for any VA ARM product that adjusts in less than five years. Previous attempts to introduce such loans in the 1970s were thwarted by Congress due to fears that they would leave borrowers with unmanageable mortgage payments.

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.

Keep in mind that if you cannot afford your payments, you risk losing your home to foreclosure. Once the ARM’s fixed-rate period ends, changes happen periodically and what you pay one month could increase the next month. These regular adjustments can be harder to predict and budget for, so an ARM may not be a good option if, for example, you have an unpredictable income or struggle with budgeting in general.

Consider consulting with a professional financial advisor to review the mortgage options for your specific situation. The main advantage of a fixed-rate loan is that the borrower is protected from sudden and potentially significant increases in monthly mortgage payments if interest rates rise. If you’re buying a short-term home and plan to move away or upsize in a few years, an ARM could save you money. You could benefit from the lower rate and payment, then sell your home before the rate adjusts. An ARM can also be helpful in a rising-rate market where high fixed rates are pricing buyers out of the homes they wanted. Buying a home requires more than just saving up to get a mortgage and finding your perfect home.

An ARM doesn’t make sense if you’re buying or refinancing your “forever home” or if you can only afford the teaser rate.