What is an Adjustable-Rate Mortgage ARM?

The initial interest rate on an adjustable-rate mortgage is sometimes called a “teaser” rate, and ARMs themselves are sometimes referred to as “teaser” loans. There are different types of ARMs to choose from, and they have pros and cons. ARMs offer flexibility, allowing homeowners to benefit from lower initial rates and potentially lower payments if market rates decrease. However, this comes with the risk of rising payments if rates increase. Our goal is to give you the best advice to help you make smart personal finance decisions. We follow strict guidelines to ensure that our editorial content is not influenced by advertisers.

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Then, the rate adjusts every year after that, which is what the second number indicates. One of the major cons of ARMs is that the interest rate will change. This means that if market conditions lead to a rate hike, you’ll end up spending more on your monthly mortgage payment. ARMs are great for people who want to finance a short-term purchase, such as a starter home. Or you may want to borrow using an ARM to finance the purchase of a home that you intend to flip.

• Keep in mind that if you cannot afford your payments, you risk losing your home to foreclosure.
• Buying a home requires more than just saving up to get a mortgage and finding your perfect home.
• There are various features that come with these loans that you should be aware of before you sign your mortgage contracts, such as caps, indexes, and margins.
• The 30-year mortgage, which offers the lowest monthly payment, is often a popular choice.
• If you persist with paying off little, then you’ll find your debt keeps growing, perhaps to unmanageable levels.

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There are various features that come with these loans that you should be aware of before you sign your mortgage contracts, such as caps, indexes, and margins. It’s also possible to secure an interest-only (I-O) ARM, which essentially would mean only paying interest on the mortgage for a specific time frame, typically three to 10 years. Once this period expires, you are then required to pay both interest and the principal on the loan. Mortgages allow homeowners to finance the purchase of a home or other piece of property.

• If interest rates are high and expected to fall, an ARM will help you take advantage of the drop, as you’re not locked into a particular rate.
• The interest rate for ARMs is reset based on a benchmark or index, plus an additional spread called an ARM margin.
• Borrowers with fixed-rate loans know what their payments will be throughout the life of the loan because the interest rate never changes.
• 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.
• This can make ARMs attractive for buyers who plan to sell or refinance before the adjustable period begins.

Pros of an adjustable-rate mortgage

Generally, the initial interest rate on an ARM mortgage is lower than that of a comparable fixed-rate mortgage. After that period ends, interest rates — and your monthly payments — can rise or fall. Unlike ARMs, traditional or fixed-rate mortgages carry the same interest rate for the life of the loan, which might be 10, 20, 30, or more years.

CFPB Report Finds Significant Drop in Annual Mortgage Applications and Originations in 2023

• Still, borrowers considering an ARM should always plan for the worst-case scenario.
• After that initial period, the rate adjusts annually or according to the terms set by the lender, which might be more or less frequent.
• An ARM may make good financial sense if you only plan to live in your house for that amount of time or plan to pay off your mortgage early, before interest rates can rise.
• If you don’t refinance, your mortgage payments may rise significantly once the fixed-rate period ends.
• If you’re in the market for a home loan, one option you might come across is an adjustable-rate mortgage.
• Learn more about how fixed-rate mortgages compare to adjustable-rate mortgages, including the pros and cons of each.

Rate adjustment periods define how often the interest rate on an ARM can change after the initial fixed period. Common adjustment periods include annually (1-year ARM) or every six months. The terms of the rate adjustment are outlined in the mortgage contract. Most mainstream ARM loan payments include both principal and interest. The only time you won’t pay principal on an ARM is if you opt for a special product like an interest-only or payment-option ARM. These can offer a lower payment that covers just the interest, or possibly not even all the interest due, for a period of time.

Interest-only ARM loans

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 to compare mortgage rates?

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.

• In many cases, ARMs come with rate caps that limit how much the rate can rise at any given time or in total.
• But this compensation does not influence the information we publish, or the reviews that you see on this site.
• Your lender will also have rate caps in place that will determine how much your rate can increase each period and how high your rate can go over the life of your loan.
• Rates rose significantly in 2022, making an adjustable-rate mortgage a great option for many would-be homeowners and refinancers.
• The initial interest rate on an adjustable-rate mortgage is sometimes called a “teaser” rate, and ARMs themselves are sometimes referred to as “teaser” loans.
• Occasionally the adjustment period is only six months, which means after the initial rate ends, your rate could change every six months.

How Fixed Interest Rates Work

The offers that appear on this site are from companies that compensate us. But this compensation does not influence the information we publish, or the reviews that you see on this site. We do not include the universe of companies or financial offers that may be available to you. Some adjustable-rate mortgage loans come with an early payoff penalty.

Key Differences Between Fixed and Adjustable-Rate Mortgages

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.

How much does 1 point lower your interest rate?

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.

Understanding Rate Adjustment Periods

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.

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 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.

Pros of an Adjustable-Rate Mortgage

Shorter-term mortgages offer a lower interest rate, which allows for a larger amount of principal repaid with each mortgage payment. So, shorter term mortgages usually cost significantly less in interest. In a fixed-rate mortgage, the interest adjustable rate mortgage rate is set at the beginning of the loan and does not fluctuate with market conditions. This fixed rate is typically determined based on the borrower’s creditworthiness, the loan term, and prevailing market rates at the time of origination.

What is a mortgage rate?

• Before the 2008 housing crash, lenders offered payment option ARMs, giving borrowers several options for how they pay their loans.
• So with a 5/1 ARM, you have a 5-year intro period and then 25 years during which your rate and payment can adjust each year.
• There are certain features that might entice you to choose an ARM over a fixed-rate mortgage.
• Your mortgage loan officer can share their thoughts with you on this, but it’s also a good idea to do your own research and understand what kind of trends you should be watching.
• During that time, the monthly payments will be low (since they’re only interest), but the borrower also won’t build any equity in their home (unless the home appreciates in value).
• Unlike fixed-rate borrowers, you won’t have to make a trip to the bank or your lender to refinance when interest rates drop.

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.

Advantages of adjustable-rate mortgages

They can help you navigate the complexities of mortgage options and make the best decision for your needs. When fixed-rate mortgage rates are high, lenders may start to recommend adjustable-rate mortgages (ARMs) as monthly-payment saving alternatives. Homebuyers typically choose ARMs to save money temporarily since the initial rates are usually lower than the rates on current fixed-rate mortgages.

When you get a mortgage, you’ll pay interest on the money you borrow. Your interest rate can be either fixed or adjustable — sometimes called variable. This booklet helps you understand important loan documents your lender gives you when you apply for an adjustable-rate mortgage (ARM). With nearly two decades in journalism, Dori Zinn has covered loans and other personal finance topics for the better part of her career. She loves helping people learn about money, whether that’s preparing for retirement, saving for college, crafting a budget or starting to invest. Her work has been featured in the New York Times, Wall Street Journal, CNN, Yahoo, TIME, AP, CNET, New York Post and more.

A 5/5 ARM is a mortgage with an adjustable rate that adjusts every 5 years. During the initial period of 5 years, the interest rate will remain the same. After that, it will remain the same for another 5 years and then adjust again, and so on until the end of the mortgage term. A major advantage of an ARM is that it generally has cheaper monthly payments compared to a fixed-rate mortgage, at least initially.