Pros and Cons of an Adjustable-Rate Mortgage
Arizona homebuyers are starting to hear more about the benefits of purchasing a home with an adjustable-rate mortgage – or an “ARM loan”. That’s because ARM loans offer some serious benefits during times of higher interest rates. In fact, as interest rates rose across the board in 2022, the number of borrowers that chose an adjustable-rate mortgage doubled.
What is an Adjustable-Rate Mortgage?
Adjustable-rate mortgages are home loans with interest rates that can go up or down over time depending on the interest rate market. Contrast that to more traditional fixed-rate mortgages that maintain the same interest rate over the life of the loan.
At first glance, this may not sound as appealing as a fixed-rate mortgage which gives you the peace of mind knowing your payment remains the same each month. However, there are certain scenarios when adjustable-rate mortgages may be the perfect choice when purchasing a home with a mortgage.
How Does an Adjustable-Rate Mortgage Work?
Unlike a fixed-rate mortgage where the interest rate on the mortgage remains the same for the life of the loan, an adjustable rate mortgage does exactly what it sounds like — it adjusts.
The appealing part of a mortgage with an adjustable-rate is the introductory or teaser rate.
The teaser rate is set at a fixed rate for a period that can last anywhere from three to ten years. Once the introductory period is over, the rate moves to a variable (or adjustable) rate for the remainder of the loan.
How much the rate changes is dependent on the ARM Caps.
ARM caps are the maximum amount the interest rate can go up and are broken down in three different ways:
- The first rate adjustment immediately after the introductory fixed rate period.
- The subsequent adjusted interest rate caps which is the maximum amount the rate can increase periodically throughout the loan.
- The lifetime rate cap, or the maximum the interest rate can increase during the entire loan term.
When looking at the ARM caps, one of the questions you should ask your mortgage lender is exactly how much your payment will be with all three rate caps and then determine if you'll be able to afford the monthly mortgage payment if you were to reach the ARM's caps during the life of the mortgage.
Pros of an Adjustable-Rate Mortgage
Adjustable-rate mortgages typically start with lower rates. ARM loans start with a fixed-rate introductory period that lasts from 3 to 10 years depending on your lender. Often, you’ll find that lenders offer ARM loans with introductory periods that are significantly lower than you’ll find with a fixed-rate loan.
Adjustable-rate mortgages can offer more flexibility. If for whatever reason you know you'll be moving in a few years, then an adjustable-rate mortgage may be a better option for you. You will pay less interest because you'll benefit from the lower teaser rate. The key is you'll need to sell or refinance your home before the introductory period ends and your variable rate starts.
Your payments may go down over time. When people hear that an ARM loan “adjusts,” they always think of rates going up. However, your monthly payments could decrease if interest rates fall during the variable rate period. That could save you the cost and time of refinancing your home loan for a new term.
Cons of an Adjustable-Rate Mortgage
Your payments may go up over time. This is the biggest downside for someone considering an adjustable-rate mortgage. After the introductory period, your monthly payment adjusts depending on interest rate indexes. Rising interest rates would mean a higher monthly payment for you.
The uncertainty of variable payments. With a fixed-rate loan, there's comfort in knowing exactly how much you have to budget for each month’s mortgage payment. With an ARM loan, interest rates and monthly payments may rise significantly outside of your budget and make your monthly mortgage payment unaffordable.
Adjustable-rate mortgages are more complex than fixed-rate mortgages. Things like ARM caps, margins, adjustment indexes and other confusing terms can make it difficult to navigate the mortgage process. It is always recommended that you work with an experienced lender at a local bank or credit union when determining exactly how your ARM is structured.
How Often Will My Rate Adjust?
Understanding when and how often your interest adjusts is a key part of knowing whether an ARM loan is right for you.
Most ARM loans are hybrid loans that are broken into two phases: the fixed-rate period and the variable-rate period.
You’ll see these loans expressed as 3/1, 5/1, 7/1 and 10/1 OR 3/6, 5/6, 7/6 and 10/6
- The first number is how long the introductory fixed-rate will last in years. In both cases above, it’s 3, 5, 7, or 10 years.
- The second refers to how often the rate can change after that. In the cases of the 3/1, 5/1, 7/1 and 10/1 loans, this is once every year or annually. For 3/6, 5/6, 7/6 and 10/6 loan the interest rate would adjust every 6 months.
Frequently Asked Questions
Before you decide on whether an adjustable-rate mortgage is better for you than a mortgage with a fixed rate, let's take a look at some of the questions you may be asking yourself.
What Happens When an Adjustable-Rate Mortgage Adjusts?
The worry so many borrowers have is what happens if things don’t go as planned. Maybe you thought you were going to move before the introductory period ended and now things have changed.
If this happens, then your best option is to refinance your mortgage into a fixed-rate mortgage. However, if interest rates have increased since you first started your ARM, then the risk is you would be refinancing into a higher rate than if you would have just started off with a fixed-rate mortgage when interest rates were lower.
Is an Adjustable-Rate Mortgage the Same as a Variable-Rate Mortgage?
Yes, the terms are interchangeable.
How are the Interest Rates Calculated with an ARM?
The lender you choose will determine which of the three indexes they will use to set your rate. A "margin" will then be added to the rate which is a fixed percentage added to the index rate to calculate the new rate.
How Much Can My Interest Rate Adjust?
When obtaining an adjustable-rate mortgage, it's important to understand the ARM Caps. This will tell you the maximum your rate can go up after the introductory period ends, the maximum it can increase each year throughout the loan, and the maximum it can increase through the life of the loan.
Final Thoughts
When Arizona homebuyers are exploring their mortgage options, it may be a great idea to go with an adjustable-rate mortgage. However, make sure you have a plan in place for when the rate does adjust and always play it safe by anticipating on the rate adjusting higher.
When working with your lender and determining your future payments using the ARM caps, decide whether or not you could afford the increase monthly mortgage payment if the rates do increase to the maximum amount.
By Chris “Peach” Petrie,
Founder of Money Peach
Chris “Peach” Petrie is the founder of Money Peach. Money Peach partnered with OneAZ to provide free financial education to members across the state. To learn more about OneAZ’s partnership with Money Peach, click here.
APR = Annual Percentage Rate
