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Adjustable-rate mortgages (ARMs) typically start with lower interest rates and payments than their fixed-rate counterparts. Once a rarely used option, ARMs are now getting a second look from homebuyers looking for more affordable options amid elevated home prices and interest rates.
An adjustable-rate mortgage can be beneficial if you only plan to stay in your home for a few years, before the rate adjustments kick in. If you plan on staying in the home long-term, however, a fixed-rate mortgage may be a better option to lock in your rate and safeguard against future rate hikes.
What Is an Adjustable-Rate Mortgage?
As its name suggests, an adjustable-rate mortgage is a type of home loan with an interest rate that fluctuates over the life of the loan. ARMs begin with a fixed-rate period, which can range from six months to 10 years, but is typically for three, five or 10 years. Generally, the initial fixed-rate period features a lower rate than a similar fixed-rate mortgage. Once the fixed-rate period ends, the ARM switches to a variable rate for the remainder of the loan term, known as the adjustment period.
The most common type of ARM is the 5/1 ARM. In this case, the "5/1" refers to the fixed-rate period (five years) and how frequently your mortgage's annual percentage rate (APR) adjusts after that (once every year). Similarly, a 5/6 ARM comes with an initial five-year fixed-rate period followed by a variable-rate period that adjusts every six months.
ARM adjustments are based on a benchmark like the one-year Treasury bill, Secured Overnight Financing Rate (SOFR) or another index. When your mortgage adjusts, your payment may be higher or lower than your payment during the beginning fixed-rate period.
Pros of an Adjustable-Rate Mortgage
An adjustable-rate mortgage offers several advantages that may benefit you, depending on your financial situation.
Lower Initial Payments
ARMs typically offer lower interest rates during the fixed-interest period than similar 30-year fixed-rate mortgages. In the past 15 years, the rates during an ARM's initial term have been about 0.5 to 1.5 percentage points lower than the rates on a conventional 30-year mortgage. These reduced rates may result in lower mortgage payments that make homebuying more affordable.
Flexibility May Benefit Short-Term Borrowers
If you only plan to keep your property for a few years, an adjustable-rate mortgage may help you keep your borrowing costs lower before you sell the property. Keep in mind, however, that many lenders discourage this strategy by imposing hefty prepayment penalties, which may offset any savings. Also, this tactic could backfire if the local housing market drops and it becomes harder to sell your home.
Interest Rates May Drop
As noted, mortgage rates are typically tied to an index and adjust periodically. As such, your interest rate and payments may go up or down accordingly. Mortgage professionals often recommend preparing yourself for higher payments if your loan adjusts upward. However, if interest rates are high during the fixed-rate period, they may begin to fall once your adjustment period begins. In that case, your interest rate and monthly payments will lower and become more affordable.
Cons of an Adjustable-Rate Mortgage
Of course, an adjustable-rate mortgage isn't for everyone. Consider some of the following downsides before proceeding with an ARM.
Monthly Payment Can Increase
Although ARMs may come with an interest rate adjustment cap and a maximum adjustment limit, your mortgage rate and monthly payments can increase. If you're not prepared for it, a higher payment could strain your budget and make it difficult to manage your other bills and expenses.
May Require a Larger Down Payment
The minimum down payment on a conventional ARM is typically higher than with other types of mortgages. By contrast, some conventional fixed-rate mortgages require as little as a 5% down payment. Similarly, you may qualify for a government-backed mortgage like an FHA ARM with only 3.5% down or a VA ARM that doesn't require a down payment.
Refinancing Can Be Costly
When interest rates are high, it can be tempting to finance a home with an adjustable-rate mortgage for its lower introductory rates and refinance before the fixed-rate period ends if interest rates fall. While this strategy can save you money over time, you could incur significant closing costs that can run into the tens of thousands of dollars, depending on the size of your loan.
Adjustable-Rate Mortgage vs. Fixed-Rate Mortgage
When comparing an ARM with a fixed-rate mortgage, always do the math. Working out precisely how much each loan will cost you in the initial fixed-rate period—and how much you could pay if interest rates skyrocket over the years—can help you understand short-term savings versus long-term costs.
Suppose you're buying a $500,000 home with a 20% down payment. You need a $400,000 mortgage and are choosing between a 30-year fixed-rate loan and a 5/1 ARM. Let's compare how a 30-year fixed-rate mortgage and the average starting rate for a 5/1 ARM stack up using their average rates from August 2023—7.18% and 6.20%, respectively.
| Fixed-Rate Loan | 5/1 ARM | |
|---|---|---|
| Interest rate | 7.18% | 6.20% (first 5 years) |
| Monthly payment | $2,710 | $2,450 (first 5 years) |
| 5-year cost | $162,600 | $147,000 |
During the initial fixed-rate period, you would save $260 each month by choosing the ARM over the fixed-rate loan. That translates to a five-year savings of $15,600.
At the five-year point, the interest on your ARM would adjust. If your rate rose by 0.97% or less, you would continue to have a lower monthly payment than with the fixed-rate loan. At the opposite extreme, depending on your rate cap, your interest rate could rise by as much as 5% or more. In that case, your new interest rate of 11.20% would result in a monthly payment of $3,870, over $1,400 more than your initial payment. At that rate, the fixed-rate loan would have a lower monthly payment by $1,160—and would eventually become the cheaper option in total.
That is, of course, a worst-case scenario. Historically speaking, the likelihood that your interest rate would rise maximally and stay at that level for the remainder of your loan is fairly low. However, if you're considering an ARM, you should prepare for any eventuality. Before you agree to any loan, ask about your maximum interest rate and monthly payment—then think about how you'll afford those payments if rates hit those upper limits.
What Are the Intangible Costs?
With a lower starting interest rate and monthly payments, an ARM can make a mortgage more affordable, particularly in the early years of the loan. However, it's difficult to know how much an ARM will ultimately cost because you can't see into the future to determine when your loan will adjust, whether it will adjust up or down and by how much.
That's why it's imperative to do your due diligence and ask a lot of pertinent questions before you make a decision, such as:
- When does the loan adjust?
- What is the underlying index your mortgage rate is tied to?
- What is the margin—the amount the lender adds to the index rate to determine your mortgage rate?
- What is the worst-case scenario for payments, interest rates and negative amortization?
Since it can be difficult to foresee the future to get answers to these and other questions, your rate and payments can be unpredictable. If you value predictability, you may prefer a fixed-rate loan with costs that remain fixed over the life of the loan.
Is an ARM a Good Idea?
Unpredictability may be less of a concern if, for example, you plan to sell your home by the time the interest rate resets. Your interest rate and payments are locked for the initial period, so your mortgage will be very predictable if you sell your home before the fixed period ends. It's also possible your rate won't increase, or will only slightly rise, when the adjustable period begins.
An ARM may be worth considering if you're looking for a lower-cost alternative to a fixed-rate mortgage to purchase a home. Besides the initial money you could save, a lower interest rate and payment could make it easier to qualify for a mortgage.
But if you don't want to worry about potential rate and payment increases, a fixed-rate mortgage provides you with a set-it-and-forget-it option. This predictability can provide you with peace of mind, knowing what your mortgage payment will be for the next 30 years, or for as long as you keep your mortgage.
Should You Refinance an ARM to a Fixed-Rate Mortgage?
If you do choose an ARM, you can refinance to a fixed-rate loan after your initial rate expires. But refinancing generally comes with closing costs and fees, and you'll need to watch interest rates so you can time your refinancing when rates are low.
The closing costs on a mortgage can range from 2% to 6% of the loan amount. That means if you refinance a $350,000 loan, you'd owe between $7,000 and $21,000. If you don't anticipate keeping the home for the long term, refinancing may not be worth the cost.
However, if you do plan to keep your property for the long haul, locking in a new rate—even if that rate is slightly higher than your initial ARM rate—could reduce your risk. Your mortgage rate will be shielded from any future rate changes that could impact your payment.
Good Credit Can Help You Obtain a Low Mortgage Rate
Homeowners struggling to qualify for fixed-rate mortgages may find the lower rates and monthly payments on adjustable-rate mortgages attractive. The initial fixed-rate period of ARMs can make buying a home more affordable for these buyers. By contrast, fixed-rate mortgages offer stability and predictability that risk-averse buyers may prefer.
If you're considering both types of loans, seek out different lenders to compare rates and monthly payments in a variety of scenarios. Carefully review any loan agreement, making sure you understand all of its terms before proceeding.
No matter which type of loan you choose, having good or excellent credit may help you secure a lower mortgage rate. Check your credit report and credit score from Experian for free to discover where your credit stands and learn tactics for raising your credit score. Additionally, Experian Boost®ø is a feature that can instantly increase your score for free by giving you credit for bills you already pay, like your cellphone, utilities and rent.