Is an Adjustable-Rate Mortgage (ARM) Right for You?

Deciding whether or not to choose an adjustable-rate mortgage versus a fixed-rate mortgage is a difficult one for many home buyers. There are some big advantages to variable rates, as well as some risks. We outline the pros and cons so you can make a more informed decision.

KEY TAKEAWAYS

• An adjustable-rate mortgage (ARM) is a home loan with an interest rate that can fluctuate periodically based on the performance of a specific benchmark.
• ARMs generally have caps that limit how much the interest rate and/or payments can rise per year or over the lifetime of the loan.
• An ARM can be a smart financial choice for home buyers who are planning to keep the loan for a limited period of time and can afford any potential increases in their interest rate.

What Is an Adjustable-Rate Mortgage (ARM)?

An adjustable-rate mortgage (ARM) is a home loan with a variable rate that triggers at some point in the amortization schedule. With an ARM, the initial interest rate is fixed for a period of time. After that, the interest rate applied on the outstanding balance resets periodically, at yearly or even monthly intervals.

Typically the fixed rate period is for three, five, seven, or ten years.

ARMs are also called variable-rate mortgages or floating mortgages. The interest rate for ARMs is reset based on a benchmark or index, plus an additional spread called an ARM margin. The typical index that is used in ARMs has been the London Interbank Offered Rate (LIBOR). In more recent mortgages (2020-Present) the Secured Overnight Financing Rate (SOFR) is more commonly used index.

Types of ARMs:

Hybrid ARM

These mortgages have two phases: a fixed-rate period — typically three, five, seven or 10 years — followed by an adjustable phase in which your interest rate can move up or down, depending on an index.

Most new ARMs use a benchmark index called the Secured Overnight Financing Rate or SOFR. ARMs based on this index adjust once every six months after the introductory period.

So a 5-year ARM with a 30-year term has a fixed interest rate for the first five years and a rate that adjusts every six months for the next 25 years. You also might also see 5-year ARMs called 5/6 or 5y/6m ARMs.

The naming of ARMs is slightly different than in previous years when most ARMS were based on the Libor, or London Interbank Offered Rate. Libor-based ARMs had rates that adjusted once a year after the introductory period. Instead of a 5/6 ARM, the shorthand for a 5-year ARM was 5/1.

Some possible hybrid ARMs:

• 3-year ARM, or 3/6 ARM: The interest rate is fixed for three years, and then adjusts every six months.
• 5-year ARM, or 5/6 ARM: The interest rate is fixed for five years, and then adjusts every six months.
• 7-year ARM, or 7/6 ARM: The interest rate is fixed for seven years, and then adjusts every six months.
• 10-year ARM, or 10/6 ARM: The interest rate is fixed for 10 years, and then adjusts every six months.

The initial interest rate tends to be lower with a shorter fixed-rate period. So generally you'll see lower introductory rates for a 3-year ARM than for a 10-year ARM.

Interest-only (I-O) ARM

Interest-only ARM loans only require that you pay the interest portion of the payment for the first 3-10 years (depending on your ARM structure). After the fixed rate period your loan will recast into a principal and interest loan amortized over the remaining years left.

The balance of your loan will not reduce during the interest-only period if you don’t apply more money towards your payment.

This is not a common product offered by all lenders.

How do ARM loans work?

Let's use a 5/6 ARM with a 2.25% Index and 2% Margin as an example.

The 5 represents the Introductory or teaser rate. This refers to the interest rate you pay during the loan's fixed-rate period.

The 6 represents the adjustment frequency. It refers to how often the rate adjusts after the introductory fixed-rate period.

2.25% Index. An index rate is the variable benchmark rate lenders use for ARMs.

2% Margin. Margin is a constant rate that is added to the index rate. The sum of the margin and index rate equals the rate you pay.

ARM caps

Adjustable-rate mortgages have caps on how much the interest rate can go up. They include:

• First adjusted interest rate cap: The maximum amount the rate can increase when it's adjusted for the first time.
• Subsequently adjusted interest rate cap: The maximum amount the rate can increase at each adjustment after the first time.
• Lifetime rate cap: The maximum amount the rate can go up during the loan term.

How long do ARM loans last?

An ARM loan is usually amortized over a 30 year period. The fixed-rate portion is fixed for three, five, seven, or ten years. The longer the fixed rate portion the higher the “rate” in comparison to a shorter fixed period because of the security.

Can you pay off an ARM loan early?

You can if your ARM loan is tied to a "primary occupancy" type of loan. 99% of the time these loans do not have a pre-payment penalty attached. Residential Investment properties and commercial ARM loans typically carry a pre-payment penalty that is staggered down the longer you stay in the loan.

Can you refinance out of an ARM?

Absolutely! If you have enough equity, credit, income, you can refinance out of an ARM. In fact, most people commonly refinance before the fixed rate option is about to turn variable.

How risky is an adjustable-rate mortgage?

It can be risky, if you are not looking into the future and how much equity you have. If you have plenty of equity, would be able to endure a downturn in the market, and can maintain income and good credit. You can refinance out of the ARM loan anytime. If you aren’t planning accordingly and you are upside down or end up depending on fixed-income retirement and do not have the ability to refinance you might endure a higher rate, which will put pressure on your finances. We urge you to budget and plan for the long term when taking an ARM.

For which type of buyers would an ARM be a good option?

• If this is not your forever home and you know you’ll be selling it.
• If you are thinking rates will plummet in the future, and they’re currently high due to macroeconomic conditions.
• If you plan on paying the house off faster due to a windfall of money.
• If you are trying to ease into home ownership with cheaper payments.

All buyers can take an ARM loan if they wish and budget/plan accordingly. During high-rate environments, ARM loans become a popular choice because they offer relief and cheaper rates. If you look at the rate history over the past two decades, rates have gone up and down five times. It is good for buyers to take ARM loans if they know they are not going to be in the home for long period of time.

History shows that the average person has refinanced within a 3-5 year period, and some make the argument that it’s not worth taking a 30 year lock-up period when rates could be favorable to refinance.