What is an adjustable-rate mortgage?

A mortgage is, simply put, an agreement between a buyer and a lender allowing the buyer to borrow money for a home purchase and pay it back over time, plus interest. Buying a home is a huge financial commitment, and most buyers can’t pay for it all up front, so they need financing to afford it. There are many different types of mortgages available. Keep reading to explore the perks (and drawbacks) of an adjustable-rate mortgage.

What is an adjustable-rate mortgage?

An adjustable-rate mortgage (also referred to as an ARM or a variable-rate mortgage) is a loan with an interest rate that can fluctuate during the loan period. In other words, you may end up paying more (or less) each month on the mortgage. The adjustments are based on the market.

How does an adjustable-rate mortgage work?

An ARM loan features two periods: the initial period and the adjustment period. During the initial period, which is also called the fixed-rate period, the loan’s interest rate doesn’t change. This period can be any length from six months to 10 years, although 3, 5, or 10-year periods are the most common.

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After the initial period comes the adjustment period. During the adjustment period, your interest rate can change. The interest rate will adjust depending on the conditions of the market as well as the conditions of your loan. ARM loans have caps that restrict how much your interest rate can change. These caps protect the mortgage recipient. Caps will either be annual or life-of-the-loan.

• An annual cap means that the interest rate can only go up or down a certain amount each year.
• A life-of-the-loan cap sets the maximum and minimum interest rates for the entire duration of the mortgage.

If you’re considering an adjustable-rate mortgage, it’s very important to fully understand the terms of the loan, so you know what to expect.

Types of adjustable loans

There are a few types of adjustable-rate mortgages. Below are some of the most common ARM loans that you will come across. Keep in mind that not all lenders will offer all of them:

• 5/1 ARM loans

  In a 5/1 adjustable-rate mortgage, your loan has a fixed-rate interest period for the first five years of the loan. Once the five years are up, you enter the adjustment period where your interest rate will change each year for the next twenty-five years. This is the most common adjustable-rate mortgage.

• 10/1 ARM loans

  In a 10/1 adjustable-rate mortgage, you’ll have a fixed interest rate for the first ten years of the loan. Once ten years have passed, the interest rate will adjust every year for the next 20 years.

• 5/6 ARM loans

  A 5/6 ARM loan is sometimes considered a hybrid adjustable-rate mortgage, because it’ll give you a fixed interest rate for the first five years of the loan, and once the five years are up, your interest rate will adjust every six months for the next 25 years.

• 7/6 ARM loans

  A 7/6 adjustable-rate mortgage is another hybrid ARM loan. You’ll have a fixed interest rate for the first 7 years of the loan, followed by an adjustment period that is 23 years long. During that adjustment period, the interest rate of your loan will change every six months.

• 10/6 ARM loans

  In a 10/6 adjustable-rate mortgage, you’ll have a fixed interest rate for the first ten years of the loan, followed by a 20-year adjustment period where your interest rate will change every 6 months.

As you evaluate the different kinds of adjustable-rate mortgages, think about your specific situation. For example, if you plan on living in a home for just a few years, you may want to consider a 5/1 loan, to try to avoid paying large interest fees if you sell before the adjustable-rate period starts. On the other hand, if you know you want to live in your home for a long time, you may consider a 10/6 ARM loan to lock in a fixed interest rate for ten years.

HPros and cons of an adjustable-rate mortgage

Why should you go with an ARM instead of another type of home loan? Weigh the pros and cons of each option before you decide to sign off on one:

Adjustable-rate mortgage pros

ARM loans offer several advantages. For example, if mortgage interest rates drop in time for your adjustment period, this is in your favor – once you enter the adjustment period your monthly payment amounts could decrease.

The monthly payments during the initial period are often quite affordable, and your starting rate can even be lower than a fixed-rate mortgage, making these attractive options for penny-pinching homebuyers with an eye on the market.

Again, if you aren’t planning on staying in your home for long, the advantage of an ARM loan with the right terms is that you may avoid dealing with adjusting interest fees altogether.

Adjustable-rate mortgage cons

For some, the biggest disadvantage of ARM loans is that you never know how much your interest rate may go up or down once the initial fixed period ends, so you can only plan so far into the future for certain. And there’s always the risk that your monthly mortgage payments could become more expensive.

Another potential con is that there may be prepayment penalties. This means that if you refinance your loan, pay off your mortgage early, or sell your house before paying off the loan, you may have to pay a penalty.

Finding the right mortgage can be overwhelming, but with enough information, you can make an informed choice. Try using a free mortgage payment calculator template to see how different financing scenarios may play out as you do your research.