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Is An Adjustable-Rate Mortgage (ARM) Right for Me?

2021-05-24

Some industry watchers are predicting a slow but steady rise in interest rates in 2021 and beyond, which may make adjustable-rate mortgages (ARMs) more appealing to some homebuyers since they generally offer a lower initial interest rate than fixed-rate loans.

The reason ARMs offer lower rates initially is because there’s less risk involved for the bank than with a traditional fixed-rate mortgage. If rates go up in the future, the bank may have lower risk with an ARM because the interest rate may adjust upward. With a fixed-rate mortgage, the bank is taking on the risk of rates rising over a longer time period, and then you would have a below-market rate that does not change. If rates fall in the future, you can simply refinance and get a better rate -- paying off the loan early which reduces the bank’s interest earned.

How Rates Vary

The interest rate with ARMs varies or adjusts to interest rates in the marketplace after a certain time period -- for example, the initial interest rate may be fixed for one, two, or five years and then adjust after that. This is important because mortgage payment amounts are determined (in part) by the interest rate on the loan. The higher the interest rate, the higher your monthly payment. Likewise, payments with an ARM may decrease if interest rates fall.

Many adjustable-rate mortgages are tied to the London Interbank Offered Rate (LIBOR), prime rate, cost of funds Index, or another index. “Knowing the index your mortgage is attached to may seem like a technicality, but its movement will affect how your payments will change and it’s something you should be aware of,” says Brian Shotwell, Northern Virginia Branch Manager for AAFMAA Mortgage Services LLC (AMS). “You should ask your lender what index your ARM is associated with, so you have an idea of what adjustments to expect,” he says. “At each adjustment period, you add your fixed margin to the new index for your rate.”

Pros and Cons

Among the “pros” are:

ARMs may carry a lower interest rate than fixed-rate mortgages for a certain period of time
If interest rates drop, your mortgage payment might also decrease

But there are also some “cons” to consider:

If interest rates rise, so can your monthly payments
The guaranteed rate is only for a limited time

“So, while you may benefit from a lower initial mortgage payment with an ARM, interest rates may rise. If that happens, your monthly payment could increase during your adjustment periods,” says Shotwell.

Understanding Caps

Caps are limits on how much your ARM can actually adjust. There are three kinds of caps. An initial cap is how much your interest rate can increase in the first adjustment after your fixed period expires. A subsequent or periodic cap limits how much your ARM rate can change each adjustment period. A lifetime cap limits the maximum interest rate allowable and applies to the entire duration of the mortgage.

Borrowers can often choose between a 2/2/6 or a 5/2/5 interest rate cap structure. In these quotes, the first number refers to the first increase cap, the second number is a periodic 12-month incremental increase cap, and the third number is a lifetime cap. So let’s say you have an ARM with a 2/2/6 rate cap, that means it can adjust 2% up or down at the first adjustment, then another 2% each year thereafter, but not more than 6% for the life of the loan. During the initial rate period, your interest rate is set and fixed for that time period before an adjustment can occur.

For example, with a 10/1 ARM, the interest rate remains fixed at its original term for 10 years, then can adjust every year (up to the cap, if there is one). With a 7/1 ARM, the initial interest rate is fixed for 7 years, and then can adjust every year (up to the cap, if there is one). With a 1-year ARM, the rate is fixed for one year then can adjust annually up to any caps.

It’s also possible that caps may differ over the life of your loan. For example, the first adjustment may be up to 5%, while subsequent adjustments may be capped at 2%. If this is the case, you could be facing a hefty increase (or decrease) in your monthly payments when the first reset rolls around, depending on how the index has moved.

Finally, your lender should notify you before any adjustment change, up or down, so you’ll know in advance what’s going to happen and you can make changes accordingly. For instance, you might want to refinance into a fixed rate.

The bottom line with ARMs: you need to know what you’re getting into.

If you’re considering an ARM loan, consult with an AMS Military Mortgage Advisor, a licensed Mortgage Loan Originator, to understand the pros and cons of your unique situation and help you choose the right mortgage for your needs.

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