Adjustable-Rate Mortgages: Everything You Need to Know

adjustable-rate mortgage

With interest rates moving up, more borrowers are considering adjustable-rate mortgages (ARM) due to their (initially) lower interest rates. Of course, the interest rate on adjustable-rate mortgages is, well, adjustable, so while many consider them, a lot of home buyers decide against them after thinking about it. Is one right for you? Here’s what you need to know and ought to consider.

Mortgage Interest Rates Don’t Only Go Up

While your interest rate is adjustable, that doesn’t mean it will only go up.

First, you can choose among several different fixed-rate periods, the number of years during which your interest rate will not change at all. The options include one, three, five, seven and 10 years; the longer the fixed-rate period, the higher your initial interest rate will be. Until your fixed period is over, the lender cannot change your interest rate.

Don’t get an adjustable-rate mortgage just because the payment on the fixed is too high for you, because eventually the adjustable payment could be higher.

When your interest rate does change, the lender can’t just make up the new rate. Your NOTE — your contract with the lender — will identify an index and a margin that the lender must use to calculate your new interest rate. If underlying interest rates go down, your interest rate goes down too.

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Adjustable-Rate Mortgages are Generally Less Expensive Over Time

Because the initial interest rate is lower, you are paying your principal down faster in the early years of your mortgage. Therefore, not only are your monthly payments lower, but the amount of your payment that goes to principal is higher.

Even if you assume the worst possible case and interest rates rise as fast as your contract allows, your cumulative cost for an adjustable-rate mortgage is lower for 18 to 30 months after the initial adjustment. You’ve saved so much during the fixed period that your rate has to go very high and even then, it takes time before you’ve spent more on the adjustable-rate mortgage.

Further, unless rates spike high and stay there, your cumulative cost will almost always be lower than that of a fixed-rate mortgage.

Adjustable-Rate Mortgages Can be Harder to Qualify For

On the downside, it can be harder to qualify for adjustable-rate mortgages. Because the rate could eventually rise and the lender wants you to be able to make those payments, for the purposes of qualifying your income for the loan, they assume a higher interest rate than the initial rate. Depending on the product, they may use the fully indexed rate or 2 percent higher than the initial rate. This yields an assumed higher payment than the payment you’ll actually be making, so if your income is tight you may not qualify.

Who is a Good Candidate?

Don’t get an adjustable-rate mortgage just because the payment on the fixed is too high for you, because eventually the adjustable payment could be higher. Instead, a good candidate for an adjustable-rate mortgage:

  • Has secure employment and a stable income that is high enough to make the highest possible payments over the lifetime, or
  • Has windfall income (bonuses or stock options) that can be used to buy down the principal balance to mitigate future risk of rate changes, or
  • Has good reserves to draw from if need be to cover a higher payment.

Other Interesting Features of Adjustable-Rate Mortgages

Adjustable-rate mortgages are sometimes offered with an initial interest-only period to keep the monthly payments even lower in the early years. This will mean a much higher payment later on if you make only the minimum payment, but it can be a useful financial planning tool.

If you don’t like the idea of your interest rate adjusting every year, consider a 5/5 ARM. This loan is fixed for five years, then fixed for another five years, and after that is fixed for the life of the loan — only two adjustments in 30 years!

If you have more than one property, consider having a fixed-rate mortgage on one and adjustable-rate mortgages on others. That way, when interest rates fall, you benefit from lower payments on some properties while retaining your fixed-rate payment on others, if rates rise.

Mortgage Lingo You Need to Know

ARM: Adjustable-rate mortgage
Initial rate: Interest rate during the fixed period
Fixed period: The number of years for which the interest rate is fixed
Adjustment period: The time period between adjustments after the initial adjustment
Index: A market-based measure of interest rates, like the Dow Jones is a measure of stock prices (Most commonly used is LIBOR)
Margin: The amount added to the current index value to determine your new interest rate when it adjusts
Initial cap: The maximum amount your rate can rise on the first adjustment
Periodic cap: The maximum rise on subsequent adjustments
Lifetime cap: The highest your interest rate can ever go
Fully-indexed rate: The index plus the margin at any adjustment period