Adjustable-Rate Mortgage (ARM) Pros and Cons
Key Takeaways
- Adjustable-rate mortgages are an alternative to fixed-rate mortgages.
- While the rate and payment on a fixed-rate loan stay the same over time, ARMs have an adjustable rate.
- The rate on an ARM can go up or down, changing the payment as it does.
- ARMs often have a lower starting interest rate, but they present more risks than fixed loans.
Know the Benefits and Financial Risks Associated with ARMs
When you borrow to buy a home, you may decide between a fixed- and an adjustable-rate mortgage (ARM). An ARM typically has a fixed rate for an initial period of time, then the rate is tied to a financial index and moves periodically. The ARM rate could go up and down, affecting borrowing costs and monthly payments.
An ARM often has a lower interest rate during the initial period than a fixed loan, so it can be more affordable during the loan’s first several years. However, ARMs come with more financial risk because the rate is subject to changes after the initial fixed rate period ends. If you want the lowest possible starting payment and hope to move or refinance before the rate begins adjusting, an ARM may be right for you.
This guide explains the pros and cons of an ARM so you can choose confidently.
What Is an Adjustable-Rate Mortgage (ARM)?
An adjustable-rate mortgage typically has a 15- or 30-year mortgage term. The key difference between fixed- and adjustable-rate mortgages is that fixed-rate loans have a set mortgage rate and principal-and-interest payments that don't change, while an ARM offers a rate that moves (or adjusts) with a financial index.
ARMs generally have a fixed rate initially, then adjust on a set schedule. They are named for the fixed-rate period and how often it changes later. For example, a 5/1 ARM has a fixed rate for five years, and the rate then adjusts once a year. A 7/6 ARM would have a fixed rate for seven years, and the rate would then adjust once every six months.
ARMs have a rate cap, which affects how much rates can change from your initial rate. Here are some of the key differences.
Who Are ARMs Best For?
ARMs carry more financial risk because your rate could increase after the initial rate period. However, if you want to take advantage of the lower starting interest rate that ARMs offer and you plan to move or refinance before the rate begins adjusting, these loans can be a savvy financial option. The larger the mortgage, the more money a homeowner can save during the initial rate period.
If you plan to remain in your home for the long term, and you believe rates will rise sometime during the duration of your loan, then a fixed-rate mortgage could be a better fit. It provides more certainty and lets you lock in today's rate. With a fixed-rate mortgage, the rate will not change for the life of the loan.
Adjustable-Rate Mortgage Benefits
The benefits of an adjustable-rate mortgage include a lower initial interest rate, the potential for a rate decrease depending on market conditions, and built-in protection in the form of a rate cap that prevents rates from climbing too high from your starting rate. Here are some more details about the benefits of ARMs.
Lower Introductory Interest Rates
This initial fixed period generally lasts for 3, 5, 7, or 10 years depending on the loan terms. A 5/1 ARM is a popular option where the interest rate stays the same during the first 5 years of the loan, and then adjusts annually based on a benchmark index. The interest rate may increase over time as high as the lifetime cap or decrease to the interest rate floor for a given loan.
This introductory period can benefit homebuyers because they may pay much less interest during that period than they would with a fixed-rate mortgage. It particularly benefits short-term buyers with larger mortgages who plan to own their home for only a few years or refinance to a fixed-rate mortgage after the introductory period ends.
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Lower Initial Monthly Payments
Lower interest rates at the start of the loan term can lead to lower monthly payments. This can help if you want to keep your monthly mortgage payments as low as possible when you first become a homeowner.
Interest Rates Could Decrease Over Time
An ARM’s interest rate may decrease over time because its rate is tied to an index that reflects current market conditions.
After the introductory period ends, the interest rate adjusts on a set schedule (usually once a year) based on this index plus a lender-determined margin. If market interest rates decrease, the mortgage rate may also decrease at the next annual adjustment.
Refinancing Options
Homeowners with adjustable-rate mortgages often consider refinancing to gain more financial stability or better loan terms. Refinancing means paying off your current mortgage and taking out a new one, often switching from an ARM to a fixed-rate mortgage.
This can help you secure consistent monthly payments or lock in a low rate. It’s important to note that by refinancing, the total finance charges may be higher over the life of the loan.
Refinancing an ARM to another type of ARM can also be a smart option, depending on market conditions and your financial goals. This strategy is often used to secure a new introductory period with a lower interest rate, especially when the original ARM is nearing the end of its fixed-rate phase. As with any refinancing decision, weigh potential savings against closing costs and the risk of future rate increases. By refinancing, the total finance charges may be higher over the life of the loan.
Interest Rate Caps
Interest rate caps limit how much an ARM's variable rate can move. Caps limit how low the rate can go and how high it can rise. There is typically a limit on how much the rate can adjust with each adjustment and over time. The total overall limit is called the lifetime rate cap or lifetime adjustment cap.
Here's how each of the three works:
- Initial rate cap: This limits the amount your rate can adjust—up or down—from your initial (starting) interest rate the very first time it moves after your fixed rate period ends.
- Periodic (subsequent) rate cap: This limits how much your rate can change from the rate as of your most recent adjustment each additional time it adjusts, such as on the second, third, or fourth adjustment and so on.
- Lifetime rate cap: This limits how much the rate can deviate from your initial starting rate over the life of the entire loan. Note that many ARMs have a rate floor which is the lowest rate allowed regardless of any other rate caps.
These caps help ensure that mortgage rate changes stay within certain bounds to help prevent payment shock.
Adjustable-Rate Mortgage Drawbacks
While many features of an ARM can work in your favor, there are some potential downsides to consider, such as increasing monthly payments and interest rates.
Interest Rates Could Increase
As previously mentioned, interest rates can increase after the ARM’s initial fixed period, leading to higher monthly payments and more interest paid overall during the life of the loan. This could reduce your savings and create uncertainty in your budget. Depending on your loan size and term, even an increase of 1% during the adjustable period could noticeably raise your monthly payment.
Monthly Payments Could Go Up
ARMs risk higher monthly payments if market rates rise after the initial fixed-rate period. For example, if you have a 5/1 ARM with an initial rate of 3% for the first five years and a 2% initial rate cap, if rates have risen significantly in the 5 years since you took out your ARM, you may find yourself paying 5% interest when your first adjustment occurs. This could significantly raise your monthly mortgage payment and throw off your finances.
Less Predictability
Compared to other types of mortgages, ARMs are considered less predictable because the interest rate (and subsequently, the monthly payment) can change periodically based on market conditions.
While ARMs often start with a lower initial rate, the rate can increase significantly after the initial fixed period ends. This variability makes long-term financial planning harder, as future payments could rise beyond your budget if rates go up.
Penalties for Refinancing
Some lenders will charge a fee for paying off your mortgage early, known as a prepayment penalty. This can happen if you use a refinance loan to pay off your ARM early, sell your home shortly after purchasing, or make large extra payments within a certain time frame.
Some lenders utilize this fee to recoup lost interest from early payoff, so it’s important to review your mortgage agreement before taking any of these actions to avoid unexpected costs. Not all lenders charge prepayment fees, including Freedom Mortgage.
Adjustable-Rate Mortgages Today
ARM rates are primarily determined by an index—such as the Secured Overnight Financing Rate (SOFR)—used by many ARMs, plus a fixed margin set by the lender. The market rate changes based on broader economic conditions like inflation and Federal Reserve policies. As market indexes change, an ARM's interest rate typically adjusts on a set schedule (often annually or every six months).
Other factors that influence the rate for a particular borrower’s ARM may include credit history, loan amount, loan-to-value (LTV) ratio, and specific loan terms. The LTV ratio compares the loan amount to the property’s value to help lenders assess risk. Specific terms of the loan might include rate caps and the length of the initial fixed-rate period. Together, these elements determine the initial interest rate and limit how it can change over time.
ARM Alternatives
The main alternative to an adjustable-rate mortgage is a fixed-rate mortgage. A fixed-rate mortgage retains the same interest rate and monthly principal and interest payments over the entire life of the loan, which is typically a 15- or 30-year mortgage. Most types of mortgages offer a fixed-rate option, including conventional loans and government-backed programs like FHA, VA, and USDA loans.
Final Thoughts: Know When an ARM Makes Sense for You
Deciding if an ARM is right for you ultimately depends on your financial and homeownership goals. ARMs offer an introductory period where the interest rate is fixed and usually lower than that of a fixed-rate loan, allowing for potential savings. This makes them a popular choice for homeowners who plan to sell or refinance their home within a few years.
On the other hand, ARM payments may become less predictable after the introductory period ends, making them riskier than fixed-rate mortgages. If an ARM’s pros outweigh the cons and reflect your needs, get prequalified with us today to see your personalized options.
Christine Rakoczy has been a financial writer since 2008, contributing to major publications, including Credit Karma, CBS MoneyWatch, WSJ, and Forbes Advisor. While her special focus is diving deep into mortgages, Christine has extensive experience with all types of financial topics.
In addition to writing for online articles, Christine has also taught business administration courses at a career college and has served as a subject matter expert on numerous business and legal courses.
Christine earned her JD from UCLA School of Law in 2008 and has a BA in English, Media, and Communications, with a Certificate in Business Administration from the University of Rochester.
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