When it comes to exploring mortgage options, you may have encountered the term adjustable-rate mortgage, also known as an ARM loan. But what exactly is an adjustable-rate mortgage, and how does it function? Whether you’re looking at properties for sale in Denver, CO or considering purchasing a home in Miami, FL, understanding the workings of an ARM can help you make an informed decision on your financing options.
This guide from Redfin delves into the details of what an adjustable-rate mortgage entails, how it operates, the various types available, their advantages and disadvantages, and who they may be suitable for.
Understanding Adjustable-Rate Mortgages
An adjustable-rate mortgage (ARM) is a type of home loan where the interest rate can fluctuate over time. In contrast to a fixed-rate mortgage that maintains the same rate throughout the term, an ARM typically starts with a lower introductory interest rate that adjusts periodically based on market conditions.
Functionality of an Adjustable-Rate Mortgage
ARM loans consist of two phases:
- Initial fixed-rate period: Typically 3, 5, 7, or 10 years, where the interest rate remains fixed and is usually lower than a fixed-rate mortgage.
- Adjustment period: Following the fixed period, the interest rate can adjust annually (or more frequently) based on an index (such as the SOFR or Treasury index) plus a fixed margin set by the lender.
Comparison Between ARM Loans and Fixed-Rate Mortgages
| Criteria | ARM Loan | Fixed-Rate Mortgage |
| Interest Rate | Starts lower, adjusts later | Remains the same for entire term |
| Monthly Payment | Can increase or decrease | Stays consistent |
| Best for | Short-term buyers or refinancers | Long-term homeowners |
Types of Adjustable-Rate Mortgages
ARM loans come in various structures, often denoted by two numbers (like 5/1 or 7/6) indicating the fixed period and frequency of rate adjustments thereafter. Understanding the different types of ARMs can aid in selecting the most suitable option for your financial objectives. Common ARM Types:
- 3/1 ARM: Fixed interest rate for the initial 3 years, then adjusts annually.
- 5/1 ARM: Fixed rate for 5 years, then adjusts yearly. A popular choice.
- 7/1 ARM: Fixed rate for 7 years, then adjusts annually. Preferred by buyers planning a longer stay before selling or refinancing.
- 10/1 ARM: Fixed rate for 10 years, then adjusts annually. Offers the lengthiest fixed period but typically with a slightly higher initial rate compared to shorter ARMs.
- 5/6 ARM or 7/6 ARM: Fixed rate for the initial term (5 or 7 years), then adjusts every 6 months instead of annually.
Tip: When comparing ARM types, pay close attention to the index, margin, and rate caps – these factors determine the extent and frequency of rate changes post the fixed period.
Essential Features of ARM Loans
| Feature | Description |
| Introductory rate | Typically lower than fixed-rate mortgages |
| Adjustment cap | Restricts the extent of rate increase during adjustments or over the loan’s lifespan |
| Index | Benchmark in the market to which the loan is linked (e.g., SOFR) |
| Margin | Fixed percentage added to the index for determining the new rate |
Qualifying for an Adjustable-Rate Mortgage
The qualification process for an adjustable-rate mortgage resembles that of a fixed-rate loan, but lenders may have specific criteria to ensure your ability to manage potential rate hikes. Common requirements include:
- Credit score: Many lenders prefer a score of at least 620–640, although higher scores can secure a lower introductory rate.
- Debt-to-income (DTI) ratio: Typically 43% or less, demonstrating your capacity to handle monthly payments even if rates increase.
- Stable income: Lenders evaluate pay stubs, W-2s, or tax returns to confirm consistent earnings.
- Down payment: Minimum down payments vary but are often 5%–10% for conventional ARMs.
- Sufficient reserves: Some lenders mandate cash reserves to cover several months’ worth of mortgage payments.
Tip: As ARM rates can rise, lenders might employ a “qualifying rate” (higher than your initial rate) to ensure your ability to afford payments post adjustments.
Refinancing an Adjustable-Rate Mortgage
Refinancing an adjustable-rate mortgage can be a prudent decision, particularly before the conclusion of your fixed-rate period or in the event of reduced interest rates. Through refinancing, you can switch to a fixed-rate mortgage for predictable payments or even opt for a new ARM if market conditions are favorable. Instances for considering refinancing include:
- Before the first adjustment: Locking in a fixed rate before your ARM resets can shield you from potential payment escalations.
- When rates are lower: Refinancing during a low-rate environment can lead to long-term savings.
- If your financial situation has changed: Enhanced credit, increased income, or reduced debt could qualify you for better rates and terms.
>> Read: Should I Refinance My Mortgage?
Pros and Cons of an Adjustable-Rate Mortgage
Pros:
- Lower initial payments: Beneficial for short-term homeowners or those anticipating income growth.
- Potential for lower long-term rates: If interest rates decline, your rate (and payment) might reduce.
- Affordability: Lower initial costs can help buyers qualify for a pricier home.
Cons:
- Rate uncertainty: Payments could significantly increase after the fixed period.
- Refinancing risk: Refinancing may be necessary if rates soar.
- Complexity: ARM terms, indexes, and caps can be perplexing.
Who Should Consider an ARM Loan?
An adjustable-rate mortgage could be suitable for you if:
- You plan to sell or refinance before the initial fixed-rate period concludes.
- You anticipate your income to rise in the near future.
- You desire a lower initial monthly payment to enhance short-term cash flow.
>> Read: How to Get the Best Mortgage Rate
FAQs Regarding Adjustable-Rate Mortgages
1. Do ARM loans always increase?
Not necessarily. ARM interest rates are linked to a market index and can fluctuate based on economic circumstances. However, many borrowers experience hikes when the adjustment period commences – particularly if rates have surged since the loan’s inception.
2. Can you refinance an ARM loan?
Absolutely. Numerous homeowners opt to refinance into a fixed-rate mortgage before the adjustment period kicks in to secure a more stable rate.
3. What is a rate cap?
Rate caps restrict how much your interest rate can elevate during an adjustment. Typically, there are three types:
- Initial cap: Caps the first adjustment
- Periodic cap: Caps subsequent adjustments
- Lifetime cap: Maximum increase in rate over the loan’s lifespan
In Conclusion: Is an Adjustable-Rate Mortgage Suitable for You?
ARM loans offer initial lower rates, which can be a wise financial choice for certain buyers – particularly those with brief-term homeownership intentions or expectations of declining rates. However, they carry the risk of escalating payments, necessitating a thorough assessment of your financial stability, market trends, and long-term plans.
Always compare your choices and consult with a mortgage lender to find the optimal fit for your circumstances.