Adjustable rate mortgage (ARM) summary

Adjustable rate mortgages (ARMs) are one of the more fascinating yet poorly understood mortgage products available for today’s homebuyers. While it’s widely known that an adjustable rate can have a significant effect on interest payments depending on which direction rates move, not everyone understands how to measure the associated risks and rewards of ARMs vs. fixed rate mortgages. Taking a moment to explore the unique components of an ARM will allow you to optimize your home financing decisions.

Table of contents

• What is an adjustable rate mortgage?
• How does an ARM loan work?
• Types of adjustable rates mortgages
• Understanding indexes, margins and caps
• ARMs vs. fixed rate mortgages
• Who should consider an ARM loan?
• Who should consider a fixed rate loan (Not an ARM)?
• ARM pros and cons
• How to find the best mortgage rate?
• Knowledgeable loan officers are here to help

What is an adjustable rate mortgage?

If you’re looking for flexibility as well as a low rate that you can depend on for the first few years of homeownership, an adjustable rate mortgage might be a winning option. Many first-time homebuyers are partiucilarly attracted to ARMs due to the introductory “teaser” rates that are comparatively lower than those of exclusively fixed rate mortgages, thus reducing monthly payments and providing an affordable entry point to homeownership.

Simply stated, an adjustable rate mortgage is a mortgage that consists of two distinct elements:

• 1. An initial fixed rate period (typically 5-, 7- or 10-year options) that features a low introductory rate.
• 2. A variable rate period for the remainder of the loan that is based on an index rate, which measures the cost of short-term borrowing.

To arrive at the effective interest rate for your adjustable rate period, the ARM is then added to your lender’s pre-established margin (also a percent). This total is what you will pay during the ARM portion of the loan.

In a sense, all ARMs are actually hybrid mortgages, combining an upfront, fixed rate period with a (longer) back-end adjustable rate period.

What do the numbers mean?

If you’re new to mortgages, you may require a brief primer on the visual presentation of ARM terms and years. In a 10/6 ARM, for example, the “10” stands for the length of the initial fixed rate period of the loan (10 years) while the “6” stands for how often the loan will reset. In this example, it’s every six (6) months.

How does an ARM loan work?

All ARMs begin with a fixed rate and they only begin to change once the allotted fixed rate period is over. Even then, they don’t change capriciously or with great frequency. Usually an ARM will either reset once a year or every 6 months. Increasingly, due to industry changes that we’ll talk about later, most mortgage providers have begun to offer ARMs that readjust every six months as they transition to the SOFR index as their preferred interest rate benchmark.

OK, so in the real world of 10/6, 10/1, 7/6, 7/1, 5/6 and 5/1 ARM options, what does this mean for your mortgage?

Let’s say you want to buy a $300,000 home and you’re considering an adjustable rate mortgage. As a first-time homebuyer, you may be attracted to the low interest rates that are prominently featured as part of the fixed rate portion of an ARM. Everything else being equal, low interest rates = low monthly payments. Sure, for risk averse individuals, a 30-year fixed rate has a strong appeal, but if you need to save money now and the initial rate for a 5/1 mortgage is cheaper than its 30-year fixed rate counterpart, you may be swayed by the savings of an ARM.

While mortgage rates can change from lender to lender, in today’s interest rate environment, it may be possible to receive an ARM that’s markedly lower than the corresponding rates of a 30-year fixed loan. For example, if you can obtain a 5/1 ARM at an initial rate of 2% vs. 3%* for a typical 30-year fixed rate mortgage, the savings over the first 60 months (5 years) can be quite substantial.

5/1 ARM example**

• 1. An initial fixed rate period (typically 5-, 7- or 10-year options) that features a low introductory rate.
• 2. A variable rate period for the remainder of the loan that is based on an index rate, which measures the cost of short-term borrowing.

You can expect to pay back $887 per month, not including taxes and other fees. Over the course of five years, this equals $53,220.

For a comparison, a 30-year fixed rate mortgage priced at 3% (1% higher than the ARM) would be $1,011 per month. This would result in payments of $60,660 over the first 5 years of the 30-year mortgage.***

$60,660 - $53,220 = $7,440

Note: the above rates assume a credit score of 714 or above.

As you can see from our example, a sizable savings ($7,440) can be recouped for borrowers who choose an ARM loan over a 30-year fixed mortgage during the initial rate period. While it’s impossible to compare future adjustable rate periods before they occur, borrowers can take some satisfaction from seeing how lower rates in the initial period can produce tangible savings.

A mortgage calculator can be quite helpful when comparing costs and rates.

Types of adjustable rates mortgages

Today, most ARM options can be divided into three loan term categories:

• 5-year ARM
• 7-year ARM
• 10-year ARM

Some lenders offer a 3/1 ARM, but for the purposes of this article, we’re only interested in the most frequently offered ARMs. This makes it easy to compare specific rates between lenders and determine if you’re getting the best deal possible.

As for the terms themselves, you may be wondering what the big deal is. After all, each of these loans feature comparatively low introductory interest rate periods and then transition to a variable rate phase. All true. But each loan contains slightly different rates, and because the fixed rate period differs, the time spent in the adjustable period on the back end of the mortgage also differs, potentially resulting in significantly higher or lower monthly payments for the remainder of the loan.

• The 5-year ARM (5/6 or 5/1) is perhaps the most popular of the ARMs. This is mostly due to the fact that the 5-year ARM offers the best rates for the initial fixed rate period. The rates are comparatively lower than a 7- or 10-year ARM mainly because the lender needs to provide you with incentive to absorb the risk on the other end of the loan—the adjustable portion. For a 30-year mortgage, a 5-year ARM will result in 25 years on the back end of the loan if you don’t sell your home or decide to refinance into a conventional fixed mortgage.

• The 7-year ARM (7/6 or 7/1) is the middle ground between the 5- and 10-year options. Its rates are not typically quite as attractive as the 5-year ARM, but are usually lower than the 10-year equivalent. A 7-year ARM will refund you 23 years in the adjustable rate period unless you decide to refinance or sell your home before the mortgage transitions to the variable rate period.

• The 10-year ARM (10/6 or 10/1) provides the least risky option out of the three readily available adjustable rate mortgages. Because the initial fixed rate period is extended to a full 10 years, the ARM period is only 20 years long. While that’s still plenty of time for rates to fluctuate wildly and create uncertainty when it comes to monthly mortgage payments, it’s still a safer bet than the 5- or 7-year ARMs. The teaser period will also feature rates that are comparatively lower than a 30-year fixed rate mortgage.

Understanding indexes, margins and caps

The adjustable mortgage rate does not by itself produce the interest rate that affects your monthly mortgage payments during the ARM period of your loan. There are other factors at play. To better understand ARMs, let’s take a look at financial indexes, margins and caps.

Index rate

All adjustable rate mortgages are generated from an index rate, or benchmark, that is based on the cost of short-term borrowing between banks. For decades, the most widely employed index for ARMs was the London Interbank Offered Rate (LIBOR) index, which was based on the cost of borrowing between certain global banks. However, because the pool of data was dangerously small and prone to fraud and manipulation, inevitable scandals around price fixing emerged. Slowly but surely, the financial sector moved away from LIBOR and as of 2020, began to embrace the more transparent and risk-free alternative known as the Secured Overnight Financing Rate (SOFR) index. This is the reference rate primarily used to determine the adjustable interest rate. Still, this is only one part of your actual rate.

Margin

The adjustable rate that affects your monthly interest payment is not solely determined by the index rate. The index rate—from the SOFR benchmark, for example— is added to your margin, which is an agreed-upon percentage established when you obtain the loan, and together, these two components create the fully indexed interest rate. This is what you will pay during the ARM period of your mortgage. Margins are generally determined by the level of risk your loan presents and do NOT change over time. A good credit score and a clean financial slate put you in the best position to earn a favorable margin from your lender.

Caps

Caps are essentially limitations on your adjustable interest rate. They were introduced to protect borrowers from wildly excessive interest rate hikes.They exist in two forms:

• 1. Annual/Semiannual Caps: These delineate how much your ARM can rise during each rate reset period, typically every six months or once a year depending on the relevant index. While this can change from lender to lender, this is typically around 2%.

• 2. Lifetime/Initial Cap: When your ARM loan transitions from the fixed rate period to the adjustable rate period, a cap can help protect you from paying an exorbitant rate, should rates rise. Caps also exist over the lifetime of the loan. For example, many lenders install caps to protect the borrower from incurring no more than a 5% hike in interest over the entire life of the loan. Check with your lender to see what caps they offer on their ARMs.

Note: Caps (or floors) also exist to prevent you from paying zero interest rates should rates plunge to that level. This is a way to ensure that lenders receive adequate compensation for making loans no matter the interest rate environment.

ARMs vs. fixed rate mortgages

If you had to boil down the difference between an ARM and a fixed rate mortgage, the one word that would be most applicable is “risk.” ARMs by their very nature are financial products vulnerable to shifts in market conditions—conditions that can’t be predicted five, seven or 10 years into the future. This uncertainty provides risk.

However, this uncertainty can also provide potential benefits. Since the future is unwritten, rates could just as conceivably drop as they could increase. Even if they stay flat or tick up a little, the built-in savings of the initial fixed rate period can result in lower overall payments than many fixed rate mortgages.

Conventional 15-year and 30-year fixed rate mortgage options are at the polar end of risk. They provide the homeowner with steady, consistent interest payments that do not change. They are great loans for the risk-averse individual.

Interestingly, while ARMs typically feature more attractive rates on the front end of their products, recent market conditions have significantly closed the gap so that fixed rate loans remain highly competitive even given the ARM’s low initial rate. Generally speaking, when interest rates are low, the argument for an ARM is more difficult to make.

Who should consider an ARM loan?

There are scenarios where an ARM is a particularly attractive loan option. Let's take a look:

• First-time homebuyers: Families and individuals buying for the first time are typically younger and at the beginning of their careers—and their savings journey. An ARM, due to the lower introductory interest rates served up during the fixed rate portion of the loan, can offer much-needed savings.**** This savings may even be the reason borrowers can afford to become homeowners in the first place. Since younger people are frequently less risk averse, they’re not as worried about the adjustable rate period. They like the flexibility of an ARM. And many—if not most—of them will sell or refinance before they have to begin paying an adjustable rate anyway.

• Homeowners looking to sell: Thinking about selling in five, seven or 10 years? If so, then an ARM could be the ideal loan product for you. Take advantage now of the appealing initial rates (typically lower than 30-year fixed rate mortgages) and then sell your home before having to face the unpredictable interest rate terrain associated with an ARM on the back end of the loan.

• Buy more home: For certain homebuyers, an ARM can be a difference maker right off the bat when selecting a home to buy. When weighing home affordability, the upfront savings obtained through choosing an ARM can sometimes be enough for prospective homeowners to take a leap towards buying the home they really want.

Who should consider a fixed rate loan (Not an ARM)?

An ARM loan is not for everyone. Let’s take a look at individuals and scenarios where procuring an ARM is probably not a great idea:

• The risk-averse borrower: As stated above, the built-in risk of adjustable rates is probably not a good loan type for anyone who is at all worried about the possibility of rates rising in future periods. In addition, it makes personal financial planning difficult. You can’t set out estimates for future savings if you don’t know how much your payments will be.

• Homeowners who intend to stay in their homes: if you intend to stay at your home for the duration, a fixed rate mortgage of either 15 or 30 years makes the most sense under most circumstances. There’s little reason to wade into the uncertainty of an ARM if you’re pleased with the rate you’ve been able to obtain and pleased with the home you’ve acquired. Any future savings due to a drop in interest rates can always be obtained through a refi.

• Homebuyers who want to avoid complexity: To the average borrower, ARMs are considerably more complex to understand than a typical fixed rate loan. An adjustable rate mortgage affords lenders the flexibility to determine adjustment indexes, margins, caps and more. The flexibility is nice but the aggregate range of factors can make things complicated.

• Buyers wary of negative amortization loans: This is a certain type of adjustable rate mortgage where borrowers can end up owing more money than they did to begin with. The reason is that the payments are set so very low, that even the interest is not being completely paid off. All of this then, naturally, gets rolled over into the balance, which can be substantial when all is said and done. If you suspect the mortgage rate being offered will not be sufficient to cover your monthly interest payments, consider this a red flag. Everyone should be wary of negative amortization loans—not just the risk averse.

ARM pros and cons

At this point, it should be clear that ARMs provide benefits as well as some potential risks.

Pros

• Upfront savings

• Lower rates that may allow you to “buy more home”

• Flexibility to get in and get out (before ARM period) by selling or refinancing

• Possibility of lower payments if interest rates fall

Cons

• During the ARM period, rates can rise dramatically (even given caps)

• Hard to understand compared to a conventional fixed-rate mortgage

• Since rates can rise or fall, it makes financial planning difficult

• Risk, risk, risk

How to find the best mortgage rate?

In today’s housing market, there are a wide variety of mortgage products available to you when looking to finance a home purchase. And many prospective homeowners find this variety useful. Purchasing a home and arranging a way to pay for it is one of the most momentous decisions you’ll ever make, and it should always be approached by first conducting the necessary due diligence as well as taking a moment to assess your own financial situation, including the full scope of your purchasing power.

Finding the best mortgage rate on the market is a process that begins long before you sit down with a loan officer. Establishing creditworthiness, which tracks your ability to borrow and repay debts on time and includes your credit score, is foundational to your pursuit of obtaining superior rates, and is best achieved through years of careful credit maintenance and timely payments.

The other half of the equation is going out into the world of banks and mortgage providers and finding a trusted and professional lender who will give you the best deal based on a range of factors including your credit, income, home price and down payment. This is your chance to explore different mortgage products, ask questions and try to enhance your mortgage IQ as you seek to better understand the current mortgage rate environment. The more prepared and knowledgeable you are, the better chance of obtaining a superior mortgage rate.