What is an Adjustable Rate Mortgage (ARM)?

Mortgages aren’t one-size-fits-all. So if you’re thinking about purchasing a home, it’s important to understand all loan options available to you.

Some people believe a fixed-rate home loan is the safest, best choice. Although this type of loan has an interest rate that never changes, thus offering predictable monthly payments, it may not be the best loan for borrowers in certain circumstances. Depending on your situation, an adjustable-rate mortgage (ARM) might be a better fit.

What is an ARM?

An ARM is a home loan where the interest rate changes or resets based on market conditions. These loans do have a fixed-rate period, during which the mortgage rate remains the same for a certain number of years.

Once the fixed-rate period ends, the mortgage rate resets every year thereafter. The different types of adjustable-rate mortgages include 5/1, 7/1, and 10/1 options.

Let’s say you get a 5/1 ARM. In this case, you’ll pay a fixed rate for the first five years of the loan. After the first five years, the rate resets every year thereafter. And with each rate adjustment, your mortgage rate will either increase, decrease, or remain the same.

While ARMs can be riskier products, they do include protections to help minimize payment shock in the event of an interest rate increase. They have an initial adjustment cap to ensure your interest rate can only increase by a maximum of typically 1% or 2% at the first adjustment.

With this cap, you can estimate the worst-case scenario, and from here, determine whether an ARM is financially feasible in the future.

After the initial rate adjustment, ARMs also include subsequent adjustment caps. This limits how much your interest rate increases with each rate adjustment going forward. This cap might be no more than 2%. There’s also a lifetime adjustment cap, where your mortgage rate will never increase by more than a certain number of percentage points.

Who Should Get an Adjustable-Rate Mortgage?

Since ARMs can be unpredictable and increase your mortgage payment, you might ask: How are these loans beneficial?

The truth is, ARMs aren’t right for all borrowers. One benefit of an ARM is that the initial rate is usually lower than the rate offered on many fixed-rate mortgages. For this reason, getting an ARM can help you save on interest charges, and by extension, reduce your monthly payment during the initial fixed-rate period.

But the opportunity to get a lower mortgage rate isn’t a reason to choose an ARM. For the most part, ARMs are better suited for borrowers who don’t intend to live in a property long-term.

So if you know that you’ll move within the next five or seven years—before your first-rate adjustment—an ARM can be a cheaper, affordable solution.

Also, ARMs are a better fit for borrowers who expect their income to increase in the future. But only if they’re confident in their ability to handle possibly higher payments down the road—if they decide NOT to move.

On the other hand, if you don’t foresee moving in the near future, you’re probably better off with a fixed-rate mortgage. You can keep your monthly payments predictable, which makes it easier to budget long-term.

Bottom Line

An ARM can often result in a lower interest rate and a lower monthly payment. But this mortgage isn’t right for everyone. To learn more about ARMs and other lending solutions, call the loan experts at Blue Spot Home Loans or complete the contact form.