Thinking About an Adjustable-Rate Mortgage? Here’s What You Need to Know.

Written by Admin | Sep 22, 2022 4:00:00 AM

Adjustable-rate mortgages (or ARMs) became a popular loan product in the 1980s when interest rates were rising and homebuyers wanted to buy a home while making the lowest monthly payment possible.

In a rising rate market like we have today, ARMs are again emerging as a loan product that may offer a lower interest rate at the outset than loans with a fixed-rate. But there’s also a level of uncertainty about how much your monthly payment may go up or down in the future.

“ARMs do offer some benefits in a rising-rate market but there are also some drawbacks Members need to understand,” says Rick Maines, AMS’s Construction Loans and Training Manager.

ARMs are available with conventional, VA and FHA loans.

“Many homebuyers choose an ARM to take advantage of the lower mortgage rates, but they must understand how ARMs work and the different types of ARMs to make an informed decision.”

How Do ARMs Work?

The interest rate for an ARM loan can change or adjust throughout the life of the mortgage, which means over time your monthly payments may go up or down. (This differs from a fixed-rate mortgage that has an interest rate that is set when you take out the loan.)

ARMs have two distinct periods:

Initial period (also known as the fixed-rate period) — During this time, the interest rate on your loan won’t change. The most common terms for the initial period are 3, 5, 7 or 10 years. After the initial period, the interest rate may adjust according to the current market
Adjustment period — ARMs have adjustment periods that determine when and how often the interest rate can change. For instance, your loan may be set for an initial period of three years and then adjust. Your new interest rate will be based on your individual loan terms and the current market. You should be sure you are financially prepared for rate adjustments if you are considering an ARM.

The Different Types of ARMs

Most lenders offer different types of ARMs. The names of these products indicate the length of the initial period and how often in a year your rate can adjust during the adjustment period.

For example, with a 5/1 ARM, the interest rate doesn’t change for the first five years (the “5”). After that, you can expect rate adjustments once a year (the “1”).

How High or Low Can Your Rate Go?

ARMs typically offer a rate cap structure to limit how much your rate can increase or decrease.

There are three different caps:

Initial cap — Limits how much your rate can increase or decrease when your rate first adjusts.
Periodic cap — Limits how much your rate can increase or decrease from one adjustment period to the next.
Lifetime cap — Limits how much your rate can increase or decrease over the life of your loan.

Here’s how that works: With a 5/1 ARM with a 5/2/5 cap structure, your interest rate can change in the sixth year but may only increase by a maximum of 5 percentage points (indicated by the first "5") above the initial interest rate. Each year after that the rate can adjust a maximum of 2 percentage points (the second number, "2"), but your interest rate can never increase more than 5 percentage points (the last number, "5") over the life of the loan.

“When shopping for an ARM, it’s important to look for interest rate caps you can afford,” notes Maines. Your mortgage company is responsible for notifying you of any changes to your interest rate in advance, but you’ll also want to keep an eye on adjustments as sudden increases in your mortgage payment can put a dent in your budget.

When Should You Consider an ARM?

According to Maines, you might consider an ARM if:

You plan on moving or selling your home within five to seven years, or before the adjustment period of the loan.
The interest rate on the ARM is significantly less than that of a 30-year fixed-rate loan.

“If rates are low, it would make more sense to get a fixed-rate mortgage to lock in the low rate,” he says.

When Should You Consider Refinancing?

You may want to refinance your ARM if:

Your ARM may adjust soon (especially important if you cannot afford a higher monthly mortgage payment)
Mortgage rates are low and you can lock in a low rate on a fixed-rate mortgage.

“Before you make plans to refinance later, it’s important to take into account the costs of refinancing, which are similar to what you pay when you purchase a home,” says Maines.

“You’ll want to work closely with your AMS Military Mortgage Advisor to look at the pros and cons of refinancing an ARM to make sure it makes financial sense for your situation,” says Maines.