What is an adjustable rate mortgage? – Forbes Advisor

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Buying a home isn’t just about saving for a mortgage and finding the perfect home. This also includes finding the right type of mortgage that best suits your budget – loan term, interest rate and monthly payment all play a part in what you can reasonably afford. An adjustable rate mortgage (ARM) might be something to consider when exploring different borrowing options.

What is an adjustable rate mortgage?

An ARM, sometimes called a variable rate mortgage, is a mortgage where the interest rate changes or fluctuates over the term of your loan. Other loans usually have a fixed rate, where the interest rate does not change for the life of the loan.

Usually, ARMs start out with a lower interest rate than fixed rate mortgages, but can increase (or decrease) over time.

How does an adjustable rate mortgage work?

With a fixed rate loan, you will pay a fixed amount each month for the duration of your loan, for example 15, 20 or 30 years. If you keep the same loan with the same lender, your mortgage payment will not change.

Variable rate mortgages, on the other hand, have variable interest rates. In most cases, the rate will stay the same for a set amount of time depending on the lender and the type of ARM you choose. This could mean the rate is the same for the first month or up to five years. For example, if you get a 5/1 ARM, your rate will remain fixed for the first five years and then become variable for the rest of the term.

Depending on the terms you agreed to with your mortgage lender, your payment could change from month to month, or you might not see a change for several months or even years.

Related: Current ARM rates

Types of MRAs

There are different types of ARM: hybrid, interest-only, and payment option.

Hybrid

If you’ve ever seen a purchase option like 5/1 or 7/1 ARM, it’s a variable rate hybrid mortgage. For these types of loans, the interest rate is fixed for a specific number of years, such as three, five or seven, for example. After this initial period, the rate is adjusted annually or according to the terms set by the lender, which may be more or less frequent.

The first number corresponds to the duration during which the interest rate is fixed and the second to the frequency with which this rate changes after the initial period. For example, using our same example above, a 5/1 ARM means the rate is fixed for five years and then variable every year thereafter.

Interest only

An interest-only (IO) mortgage means that you will only pay interest for a certain number of years before you have the chance to start paying down the principal balance. With a traditional fixed rate mortgage, you’ll pay part principal and part interest each month, but the total payment you make never changes.

With an IO home loan, you’ll have smaller monthly payments that will increase over time as you begin to pay off the principal balance. The longer your IO period, the higher your monthly payments will be after the IO period ends. Most IO periods last between three and 10 years.

Payment method

With an ARM payment option, you have several ways to repay your loan.

  • Traditional: This method includes a traditional split of principal and interest. It’s similar to a fixed rate mortgage, where you pay part of your principal and interest each month. This is the only option to reduce the amount you owe on your loan.
  • Interest only: With this loan, you have the option of paying interest only for a certain period of time, usually a few years, and then you pay both interest and principal for the remainder of the loan. While paying interest only sounds appealing, it can lead to additional costs when it’s time to start paying off your loan balance.
  • Minimum (or limited): You can make the minimum payment for this one, but any interest you don’t pay is added to the principal balance of the loan, which means you’re essentially paying interest on the interest. This option could be hard on your finances because regardless of your financial situation at the end of your loan term, you are responsible for the total balance owing.

Advantages and disadvantages of an ARM

While an ARM is one way to pay off your home loan, it’s not always the best way for everyone. Be sure to weigh the pros and cons before choosing this option.

Benefits of an ARM

  • Lower initial rate: ARMs tend to have lower initial interest rates than fixed rate mortgages. If you qualify for a low-interest ARM, you could pay much less interest up front.
  • A fluctuation could mean a drop in interest: Although your interest rate may go up, it may also go down. Since the rate is based on a benchmark, you might see a lower interest rate than fixed rate loans.
  • Payment limits: Although an interest rate can increase, ARMs have payment caps, which limit how much your lender can increase the rate. Caps also control the number of times a lender can increase the rate. So even though your rate is likely to go up at some point, you might not experience as big an increase as you think.

Disadvantages of an ARM

  • Potential rate hike: After the initial period, your interest rate is set to increase, usually every year. If you’re not ready for the adjustment, you could face a payment increase that you may not be able to afford.
  • Complicated structures: There is not just one type of ARM, there are several. For this reason, it can get confusing. If you don’t understand all the moving parts and do your research, you could end up paying more than expected.

ARM or Fixed Rate Mortgage: Which is Right for You?

You might want an ARM if:

  • This is not a long term home. If you don’t think you’re going to stick around for the long haul, you can take advantage of your home’s low initial interest rate and sell it before the rate adjusts to a potentially higher rate.
  • You expect to earn more. A fluctuating interest rate is best for borrowers who are financially comfortable with rising costs. If you think your income will increase over the next few years, your bank account might be able to handle an ARM. Along with that, if you’re making a lot of money right now, you can make extra payments for your loan and pay it off sooner, before the new interest rate kicks in. But make sure this is agreed with your lender, so you don’t get hit with a prepayment penalty.

You may want a fixed rate mortgage instead if:

  • You buy your house forever. For borrowers considering buying a home that they plan to keep for a long time, a fluctuating interest rate may not be the best option. If your goal is to live in the house for many years, a fixed rate mortgage might be right for you because it’s reliable and consistent.
  • You have a strict budget. Fixed rate loans mean you pay the same amount every month, so you know exactly what you’re responsible for. MRAs can be too much for your finances if your budget is tight, even if the switch is a few years away.

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