Adjustable-Rate Mortgage (ARM): Definition, Pros, Cons And FAQs

Disclaimer: As of April 12, 2021, Rocket Mortgage^® isn’t offering 5/1, 7/1 or 10/1 adjustable-rate mortgages (ARMs).

When choosing between home financing options for your next home, one of the most versatile and common types of home loans to choose from is the adjustable-rate mortgage. ARMs offer an initial period of lower interest rates and monthly payments before entering the adjustable-rate period where rates can fluctuate annually or biannually.

This article will explore how ARMs work, the different types available, and when they might be the right choice for you. Whether you’re a first-time home buyer or looking to refinance, understanding ARMs is crucial to making an informed homeownership decision.

What Is An Adjustable-Rate Mortgage (ARM)?

An adjustable-rate mortgage is a type of home loan with a fixed interest rate that lasts for the entirety of its introduction period which can last 5, 7 or 10 years. After this time, rates can increase or decrease as the loan enters its adjustment period, allowing for monthly payments to fluctuate from time to time.

Adjustable rates are expressed through fractions like 5/1 and 10/6, representing the length of the introductory period (in years) and how often rates will change during the adjustment period. If you have a 10/1 ARM, your introductory period will be 10 years, where you’ll have fixed rates and monthly payments, which can increase or decrease after this period is over.

Oftentimes, ARMs come with caps to limit how much your rate can fluctuate over the loan's lifespan, and during one single adjustment period.

One advantage of ARM loans is that they tend to have lower initial interest rates than conventional fixed-rate loans. This lower rate can be particularly appealing if you plan to sell or refinance before the adjustment period begins. However, this benefit comes with the trade-off of potential future rate increases, making it important to evaluate your financial situation and risk tolerance carefully.

Adjustable-Rate Mortgage Vs. Fixed-Rate Mortgage

Curious about the differences between fixed-rate mortgages and adjustable-rate mortgages? Your monthly payments and rates will never change if you opt for a fixed-rate mortgage, and you’re offered maximum stability over the life of your mortgage.

ARM loans, the majority of which are also known as hybrid loans, have both fixed and adjustable periods. The fixed period with stabilized rates and monthly payments can last for 5, 7, or 10 years before entering the adjustable-rate period, which can make your mortgage payments fluctuate.

Types Of ARMs

There are a few different types of ARM loans including hybrid (the most common), interest-only, and payment-option, here’s some info on each of them:

Hybrid ARMs

Hybrid adjustable-rate mortgages are loans that have both fixed- and adjustable-rate intervals followed by one another. Your fixed rate period can last 5, 7, or 10 years before entering an adjustable period in which rates can increase or decrease annually or every 6 months.

• 5/1 ARM: For a 5/1 ARM loan, your fixed interest rate period will last for 5 years before transitioning into its adjustable period which can change the interest rate once a year.
• 5/6 ARM: This type of ARM also allows homeowners to make fixed mortgage payments for the first 5 years of the loan, however, the loan's interest rate can be adjusted every 6 months after this period.
• 7/1 ARM: In the terms of a 7/1 loan, the interest rate remains fixed for 7 years. Afterwards, its interest rate can increase or decrease annually.
• 7/6 ARM: 7/6 ARM loans maintain a fixed rate for 7 years. Once this period is up, your interest rate may fluctuate every 6 months thereafter.
• 10/1 ARM: with 10/1 ARMs, mortgage rates, and monthly payments remain the same for 10 years before interest rates and payments can adjust annually.
• 10/6 ARM: These types of ARMs require homeowners to make fixed payments for 10 years. At the end of this time span, your loan interest rate and monthly payment can increase or decrease every 6 months.

Interest-Only ARMs

Interest-only payments allow homeowners to only make monthly interest payments for a certain amount of time. During this period, since only accrued interest payments are expected, homeowners are not required to pay any principal owed.

Payment-Option ARMs

Payment-option ARMs are types of adjustable-rate mortgages that have more flexibility for those in more specific financial situations. Oftentimes, these payment options consist of reduced mortgage payments that are interest-only, or even paying a more limited amount that doesn’t even cover total interest due. Unpaid interest is then added to your loan principal.

How Do Adjustable-Rate Mortgages Work?

An adjustable-rate mortgage is tied to market benchmarks like the U.S. Treasury or the Secured Overnight Financing Rate (SOFR), but the final rate is influenced by your credit profile, which may result in a higher number than the base market rate. Despite the variability of rates, ARMs include interest rate caps that limit how much the interest rate can increase or decrease during each adjustment period and over the loan's lifetime. These caps help borrowers manage their budget by providing a degree of financial predictability amid the potential fluctuations.

When Does It Make Sense To Take Out An ARM?

Here are a few scenarios when an ARM may make good financial sense.

You Predict Your Income Will Rise Over Time

Since ARM loans come with a potential risk of increasing over time, it would make sense to buy a new home using an ARM if you’re early in your career and expect your income to increase over the life of the loan. As your income increases, so will your sense of security in the case of interest rates increasing after the fixed-rate period of the ARM.

Since ARM rates and monthly payments usually start out less expensive than regular fixed-rate loans, you can begin the first few years of the loan with more manageable, and predictable fixed payments before you risk these payments increasing.

Interest Rates Are High When You Buy

Adjustable-rate mortgages certainly have a risk factor that comes with them. After a loan period of fixed rates, you risk increasing your mortgage rates every 6 months or annually; however, if you take out an ARM when rates are high, you’ll have a better chance at avoiding increased rates and monthly payments in the near future. ARM rates are usually lower than fixed-rate mortgages anyway, so taking advantage of ARMs when rates are relatively high can lead to more savings.

You Aren’t Planning On Being In A Home For Long

ARMs are a great financing option for first-time home buyers looking to purchase a starter home and don't plan on living in the home for an extended period of time. Whether a first-time home buyer, or just someone who doesn’t plan on living in a home for too long, if you take out the mortgage at a good time, or when rates are high, you can potentially avoid increases in your monthly payments or interest rates depending on how long you’ll be owning.

You’re Planning On Refinancing

Opting to take out an ARM with a plan to refinance your home allows for homeowners to have more flexibility and leverage when the time comes time for a refi. Since ARMs usually have lower monthly payments and initial rates, you’ll have some increased cash flow which you can put towards investments or other financial endeavors. With lower payments in the short term, you’ll have the ability to better position yourself towards a potentially better mortgage.

Adjustable-Rate Mortgage Pros And Cons

Adjustable-rate mortgages are a unique financing option for when you buy a house that has its pros and cons. Here are a few of each to help determine if an ARM is right for you.

Pros Of ARMs

• Come with lower interest rates and monthly interest payments attached
• Potential for monthly payments and interest rates to decrease over time
• Interest rate caps limit your potential financial risk
• Lower payments can help you enjoy additional savings of paying off the principal faster
• Can promote savings

Cons Of ARMs

• Interest rates may rise, causing your monthly payments to go up after your initial fixed-rate period
• Increases in payment costs may stretch your monthly budget
• Less predictable payment structure may offer you less long-term stability
• Some ARMs come with prepayment penalties attached
• Not every lender offers adjustable-rate mortgages
• Harder to budget for

Adjustable-Rate Mortgage FAQs

Here are some of the most commonly asked questions surrounding ARM loans:

What are the requirements for adjustable-rate mortgages?

To qualify for an ARM loan, ideally, you should have a minimum credit score of 580-620, a debt-to-income ratio (DTI) of no more than 50%, and a maximum loan-to-value (LTV) of 95%. When qualifying for ARMs, be prepared for a minimum down payment of 3% – 5%.

What if I get an adjustable-rate mortgage but later decide I want a fixed-rate mortgage instead?

The best option for this dilemma would be to refinance your home into a fixed-rate mortgage subject to lender approval and market conditions. This will allow you to have a sustained interest rate and future mortgage payments.

Adjustable-rate mortgage vs fixed: which is better for me?

Choosing between a fixed-rate and adjustable-rate mortgage largely depends on your financial situation and future plans. Some factors to consider prior to taking out one of the two loans would be your monthly/annual budget, how long you plan on living in the home, current interest rates, and the current state of the market. ARMs may be a better choice for those who plan on moving or refinancing within a few years of purchasing. Alternatively, fixed-rate loans provide much more stability in monthly payments, making it a safer choice if you choose to live in a home long term.

The Bottom Line: An Adjustable-Rate Mortgage May Be Right For You

Adjustable-rate mortgages are flexible home financing options that can promote significant initial savings and potential long-term benefits for homeowners. By understanding the structure of ARMs, including their fixed and adjustable periods, interest rate caps, and the various types available, you can better assess whether an ARM aligns with your financial goals and risk tolerance.

Whether you plan to move, refinance, or simply take advantage of lower initial rates, ARMs provide a viable alternative to traditional fixed-rate mortgages. If you're considering a refinance, apply with Rocket Mortgage^® today.