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Adjustable-rate mortgages (ARMs) may save you money for a temporary period on your mortgage payment and may be a good choice — as long as you know how they work.
→ ARM is short for adjustable-rate mortgage
→ You’ll typically have an initial rate lower than current 30-year fixed-rate mortgages
→ The initial rate is usually fixed for a set time ranging between one month and 10 years
→ After the initial fixed-rate period expires, the rate adjusts based on a margin and index
→ There is a set time period for rate adjustments — annually being the most common
→ There is a cap on how much the rate can increase over time
| Lender name | ARM types offered | Where they lend |
|---|---|---|
| PenFed | 3-, 5-, 7-, 10- and 15-year ARMs | All 50 states |
| Lower Mortgage | 5/5 ARMs | 43 states |
| BMO Harris | 5- and 7-year ARMs | All 50 states |
| Chase | 5/6 and 7/6 ARMs | 36 states and the District of Columbia |
| Bank of America | 5/6, 7/6 and 10/6 ARMs | All 50 states |
An ARM loan is a mortgage with an interest rate that changes. They typically feature a lower interest rate than 30-year fixed mortgages for a set time period, lasting between one month and 10 years. Most adjustable-rate loans are considered “hybrid mortgages,” which simply means they combine a temporary fixed-rate mortgage with an adjustable-rate mortgage.
An ARM loan has six components you need to understand to help you decide whether it’s the best mortgage type for you.
ARM caps are disclosed with three numbers. For example, a 5/1 ARM with 5/2/5 caps means the following:
Federal law requires lenders to provide the Consumer Handbook on Adjustable-Rate Mortgages (CHARMs) disclosure booklet and a loan estimate that details how much your rate and payment can change over time. However, the booklet is 13 pages long and may be hard to get through if you’re not familiar with mortgage terminology. To simplify things, here’s an example of how a 5/1 ARM with 5/2/5 caps could adjust if you’re borrowing $300,000 with an initial 2.5% rate.
| Interest rate for first five years | 2.50% |
|---|---|
| Interest rate for first five years | 2.50% |
| Principal and interest (P&I) payment first 5 years | $1,185.36 |
| Interest rate maximum after five years | 7.50% |
| Maximum P & I payment after five years | $1,952.62 |
| Maximum rate over the life of the loan | 7.50% |
| Maximum payment over life of the loan | $1,952.62 |
There are two common types of ARMs: hybrid ARMs and interest-only ARMs.
Hybrid ARMs. As explained above, hybrid ARMs combine an initial fixed-rate loan with an adjustable-rate mortgage after the teaser-rate period ends.
Interest-only ARMs. An interest-only ARM allows qualified borrowers to pay only the interest due on the loan for a set time, usually between three and 10 years. During that time the loan balance isn’t paid down at all.
There is another type of ARM that is rarely offered, called a payment-option ARM. It allows borrowers to choose different “options” for how they pay their loan. The three choices typically include a principal and interest payment, an interest-only payment and a minimum or “limited” payment.
With the limited payment option, borrowers can opt to pay less than the interest accruing on their mortgage, and add the unpaid interest to the loan balance. They were popular in the years leading up to the 2008 housing crash, and most lenders steer away from them.
Adjustable-rate mortgage options are available for conventional loans, loans backed by the Federal Housing Administration (FHA) and loans guaranteed by the U.S. Department of Veterans Affairs (VA).
A few things worth noting about ARMs with each type of loan program:
An ARM loan makes sense if you need to save money over a short period of time. You should choose an adjustable-rate mortgage if:
A fixed-rate mortgage is better if you prefer predictability in your monthly principal and interest payment and have long-term plans to stay in your home.
An adjustable-rate mortgage is better if you need to save money for a brief period and have a plan to refinance or sell your home before the initial fixed-rate period is over.
Because of the risk of your monthly payment becoming unaffordable due to ARM loan rate increases, lenders set more stringent qualifying guidelines than fixed-rate mortgages. In general, you’ll need:
Higher credit score minimums. Conventional loans may require a score of 640 versus the standard 620 score for fixed-rate mortgages.
Higher down payment minimums. You’ll need to come up with a higher down payment if you choose a conventional ARM loan to buy a primary residence or vacation home.
Proof you can qualify at the fully indexed payment. Some ARM programs require proof that you can qualify at the “fully indexed” payment, which is typically the maximum payment amount allowed over the life of the loan. Check with your loan officer to make sure you know the guidelines.
Yes, you can refinance a current ARM to a new ARM loan as long as you qualify.
Yes, as long as you meet the minimum fixed-rate mortgage requirements.
The rate and monthly payment could become unaffordable, making it difficult to manage your monthly payments. If you are unable to make payments, you could go into mortgage default and the lender could foreclose on your home.
Your rate can only go as high as the lifetime cap spelled out in your loan terms. Be sure you review the amortization schedule that comes with your ARM plan so you know the worst case scenario.