The Pros and Cons of Adjustable Rate Mortgages

 calculating ARM risk vs reward Adjustable-rate mortgages (ARMs) can be a great choice for homebuyers who are young, mobile, or career-driven, and who don’t mind market risk.

During the home buying process, you’re likely to be introduced to a wide variety of mortgage types. While it might seem logical to select a mortgage based upon what your friends or family have chosen, it’s more important to weigh whether or not a mortgage plan fits you and your individual lifestyle.

One of the biggest decisions you will have to make is whether to choose a fixed-rate or an adjustable rate mortgage (ARM). Though roughly 85 percent of homebuyers choose a fixed-rate mortgage, due to its affordability and stability, there are many pros to choosing an ARM for the right borrower.

For example, an ARM is often attractive to young, mobile and career-driven borrowers, mostly for its lower initial payments and flexible term features. So, what is an ARM exactly and how does it differ from a fixed-rate mortgage?

We’re here to break down the adjustable rate mortgage so you can decide if it’s the best loan choice for your home purchase.

The Adjustable Rate Mortgage Defined

An adjustable rate mortgage (ARM), sometimes known as a variable-rate mortgage, is a home loan with an interest rate that adjusts over time to reflect market conditions. Once the initial fixed-period is completed, a lender will apply a new rate based on the index - the new benchmark interest rate - plus a set margin amount, to calculate the new rate.

This new rate can increase or decrease a homeowner’s monthly payments—which may seem a little risky to more conservative borrowers. However, most ARMs have limits on how much the interest rate or the monthly payment can be changed at the end of each adjustment period or over the life of the loan. In addition, when market conditions keep interest rates low, ARM borrowers benefit. Before signing on the dotted line, borrowers should always consider the initial rate, initial rate period, and the adjustment periods when evaluating an ARM.

Why Choose an ARM?

There are several reasons why a home buyers may opt for an adjustable rate mortgage, including:

  • If you plan to sell your home or refinance before the end of the initial rate period;
  • Anticipate your income rising enough in the coming years to cover higher mortgage payments;
  • Want the initial lower payment that the ARM offers to qualify for a larger loan; or
  • Believe that mortgage rates may decline in the future, and can accept the risk (or afford higher payments) if they do not.

Like any other loan, the initial agreement spells out the terms, so you should have a clear understanding of all the details before you make a decision.

So, How Do Adjustable Rate Mortgages Work?

To understand how all of these elements work together, let’s imagine that a lender is offering a customer a 5/1 LIBOR ARM at 3.25% with 2/2/5 caps. See this table below for a brief explanation, and we go into more specific detail below.

ARM Element Element Name Element Example
5/1
(the 5 in the 5/1)

Initial rate and period

The initial rate on the loan is 3.250% for the first five years.

5/1
(the 1 in the 5/1)

Adjustment period

After 5 years, the interest rate can adjust once a year.

Market index (LIBOR, in this example)

Rate adjustment

The annual rate adjustment in our example loan is based on changes in the common (LIBOR) index.

2/2/5 caps

Rate adjustment cap

The first number is the maximum percent change allowed for the first adjustment period.

The interest rate can never adjust higher than 2% above or below the initial rate.

2/2/5 caps

Rate adjustment cap

The second number is the maximum adjustment allowed each time the rate adjusts. This is the maximum for both up or down changes.

The interest rate can never adjust more than 2% above or below the previous rate.

2/2/5 caps

Annual rate cap

The third number is the maximum adjustment allowed overall.

The interest rate can never go higher than 5% above the initial rate (3.25% + 5% = 8.25%)

What Is the Initial Rate and Period?

The interest rate that you secure when you first get an adjustable rate mortgage is called the initial rate. In many cases, the lender may offer a fixed rate for a period before the adjustment period begins. PennyMac, for example, offers adjustable rate loans with 3, 5, 7, and 10 years of an initial fixed rate. This type of ARM offers a period of predictability for the initial period, making it a desirable option for certain types of homebuyers.

What Is the Adjustment Period?

The adjustment period is the length of time that your interest rate will remain unchanged, once the initial period is over. For example, an ARM that specifies a recalculation of your mortgage interest rate at the end of each year has an adjustment period of one year. During this time, your interest rate will remain the same, but it may change from year to year depending on variations in the market index.

How are Rate Adjustments Made?

Although the specific details vary depending on the lender and your loan terms, interest rate adjustments often reflect the changes in the market index your loan uses. Many loans today are based on the London Interbank Offered Rate (LIBOR). If the market index increases, your interest rate will also likely increase. On the other hand, if the market changes favorably, your rate might decrease accordingly.

Other common indexes include:

  • Monthly Treasury Average
  • Federal Funds Rate
  • Fannie Mae 30/60
  • The Prime Rate
  • 10-yr Treasury Security
  • Discount Rate

Interest Rates Are Usually Capped

Many ARMs specify the maximum amount of each adjustment and on how high your interest rate can go over the life of the loan.

In our example, the 5/1 ARM has 2/2/5 caps. This means that at the first adjustment, the interest rate cannot go up or down more than 2 percent. The second 2 represents every adjustment after the first one. From the second adjustment to the end of the loan, the annual adjustment can't go up or down more than 2 percent. The last number in the caps, the 5, represents the lifetime ceiling adjustment. This means the interest rate will never change more than 5%, up or down, for the life of the loan.

ARMs: Risk vs. Reward

Because of the unpredictable nature of ARMs compared to a fixed-rate mortgage, you should prepare for a higher interest rate in the future. However, the initial rate for an ARM is often relatively low, so this type of loan can be a good fit in the following cases:

Brief period of ownership. If you plan to buy a home and resell it relatively quickly, you can take advantage of the lower initial rate. This also applies if you plan a mortgage refinance. In our example loan, a buyer planning on staying in the home five years or less may worry less about the adjustment period since they don't plan to own the home at the time of adjustment.

Steady income increase. If your career trajectory is likely to include a steady or predictable increase in income, you can plan for potentially higher rates in the future.

Long-term plan for rate increase. Even if you can already afford a higher initial rate now, an ARM allows you to save during the initial rate period so you can apply those savings in other ways. In our example, if the borrower is able to afford the monthly payment at 8.25%, they can enjoy the monthly payment savings from the lower initial rate, putting the money to other uses.

Risk tolerance. If you believe that the market is likely to shift in favor of lower interest rates, an ARM is a good choice, but only if you are able to pay the full interest rate.

If you are considering an ARM or would like to learn more, the Federal Reserve has provided the Consumer Handbook on Adjustable Rate Mortgages (ARM) as a reference tool that includes a checklist to help you compare mortgages.