Adjustable-Rate Mortgage (ARM): What It Is And The Pros And Cons

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

If you’re looking to purchase a property, an adjustable-rate mortgage (ARM) can help you finance your real estate holding. In fact, it’s one of the most common forms of home loan issued to borrowers and investors today.

An ARM is a type of home loan with an interest rate attached that can periodically change and fluctuate. Interest rates on ARMs typically start out lower than what you’d find on a fixed-rate mortgage.

Let’s take a closer look what an ARM is and how it works in practice.

What Is An Adjustable-Rate Mortgage (ARM)?

An adjustable-rate mortgage is a mortgage loan type with an interest rate that can fluctuate after an initial period of time. This can change your monthly mortgage payment, causing it to go up or down accordingly.

That said, ARM loans generally come with introductory rates than can be significantly lower than those associated with a conventional fixed-rate mortgage. But you’ll effectively trade risk for reward if you apply for one. That’s because, following the initial introductory period, your interest rate will be readjusted and brought in line with where rates currently sit at the time – which may cost you less or more money monthly.

Typically, ARM options are expressed numerically, and include choices such as the 5/6, 7/6, and 10/6. These numbers correspond to the length of the ARM’s initial introductory period, and how frequently rates get adjusted afterward. For example, under the terms of a 7/6 ARM, your interest rate would remain fixed and predictable for the first 7 years of the loan. The second number sets your adjustment period to 6 months – meaning that your rate will be amended once every 6 months after your 7-year introductory period is up.

Of course, there are limits to these interest rate movements. For example, ARMs tend to come with caps attached that place limits on the total amount that your interest rate is able to increase – both for a single adjustment period, and in aggregate over the entire life of the loan. Still, these rate fluctuations can prove both costly and significant, an important point to factor into your budget calculations.

Adjustable-Rate Mortgage Vs. Fixed-Rate Mortgage

Wondering what the difference is between a fixed-rate mortgage and an adjustable-rate mortgage? Your monthly mortgage payments won’t shift if you sign up for a fixed-rate mortgage. It also helps to know that a fixed-rate mortgage offers maximum stability over the life of the loan.

On the flip side, an ARM generally comes with a lower interest rate attached during its introductory period. Following this initial period though, the amount that you’ll pay monthly may change with changing interest rates. Under optimal circumstances, rates may go down, and your ARM could become less expensive over time. At the same time, if interest rates go up, your ARM could cost you more in the end.

How Do Adjustable-Rate Mortgages Work?

Think of an ARM as a home mortgage that’s split into two distinct phases: fixed and adjustable periods. During their initial, fixed-rate period (which may last anywhere from 5 – 10 years or so), your interest rate and monthly payment on an adjustable rate mortgage won’t change. But when the second phase – the adjustment period – kicks in, your interest rate may rise or fall based on the market benchmark interest rates.

While your ARM will be tied to a benchmark rate – e.g., the U.S. Treasury or secured overnight finance rate (SOFR) – this benchmark is only the beginning point for any calculations. Loan providers such as banks, credit unions and online financial technology (fintech) firms take into account your credit history and credit score, so you may see a higher rate than the baseline set by the market on your loan approval.

Sticking with an ARM loan, you’ll generally enjoy some degree of predictability here in the form of interest rate caps, which can limit how much of a jump up or down is allowed during different loan periods. Armed with this information, you can better plan your monthly budget accordingly.

Types Of ARMs

Common types of adjustable-rate mortgages include:

• 5/1 ARM – A 5/1 ARM comes with a fixed-interest rate for the first 5 years of the loan. Following this, the ARM then switches to an adjustable rate which can change every year for the rest of its term.
• 5/6 ARM – Under the terms of a 5/6 adjustable-rate mortgage, your initial introductory period lasts 5 years, during which time you’ll have a set interest rate and make predefined monthly mortgage payments. But as the second number (which denotes a 6-month adjustment period) indicates, your interest rate will be readjusted every 6 months afterward.
• 7/1 ARM – This type of ARM allows prospective homeowners, to make fixed monthly mortgage payments for the first 7 years of their loan. Afterward, interest rates can increase or decrease annually for the remainder of the loan’s term period.
• 7/6 ARM – In keeping with above entries, a 7/6 ARM sees you lock in for a fixed interest rate for the first 7 years of the loan. Once this period is up, your loan’s interest rates can adjust every 6 months for the rest of its lifetime.
• 10/1 ARM – Sign up for a 10/1 adjustable-rate mortgage, and your interest rate and monthly payments will stay the same for the first 10 years of the ARM. Having completed this initial introductory period, you’ll enter the adjustment period, where rates may rise or fall on an annual basis.
• 10/6 ARM – A 10/6 ARM carries a fixed interest rate for the first decade of the loan’s term, and an adjustable interest rate for the remainder of its lifetime, which can fluctuate every 6 months.

Adjustable-Rate Mortgage Pros And Cons

As with any financial decision you make, there are pros and cons to using an adjustable-rate mortgage to buy a house.

Pros Of ARMs

• Come with lower initial 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 exposure
• Lower payments can help you enjoy additional savings or pay off principal faster

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

When Does It Make Sense To Take Out An ARM?

There are several scenarios under which applying for an adjustable-rate mortgage may make good financial sense.

For example: If you’re starting out and early in your career, and expect your income level to rise over time, an ARM may save you money upfront when it’s needed most. However, keep in mind that there’s a certain level of risk attached. Noting that interest rates and monthly payments can climb, especially if current interest rates are high, an ARM may wind up costing you more money in the long run.

In general, if interest rates are relatively low at the time that you’re shopping for a home mortgage, it may make greater financial sense to lock this low rate for the life of the loan with a fixed-rate mortgage. Conversely, if interest rates are on the higher side, it may make more sense to choose an ARM and enjoy the benefits of a low interest rate initial introductory period instead.

Similarly, if you aren’t planning to be in your home for long, it may make sense to take out an ARM. That’s because if you sell your home before the fixed-rate introductory period is up and pay off the loan, you won’t have to worry about future rate increases. In fact, it’s quite common for those who move every few years for their jobs, or those purchasing starter homes with an eye toward moving up to something bigger shortly, to choose an ARM. Of course, plans tend to change over time, markets can fluctuate and homes can be difficult to sell at times – which could also scrap potential savings benefits. Noting this, as you contemplate whether to apply for an ARM, take time to consider what your financial situation might look like if you’re still holding onto it when the introductory rate expires.

Alternately, last but not least, many borrowers take out an ARM with an eye toward refinancing into a fixed-rate mortgage before their adjustable-rate mortgage’s introductory rate resets. In other words, they aim to strategically capitalize on an ARM’s lower initial interest rates for a time before replacing the loan with what’s hopefully an equally-advantageous fixed-rate mortgage opportunity.

The risk you take if you opt to pursue a refinancing strategy is that your situation could change and prevent you from ultimately being able to follow through with the plan. Case in point: If your credit score drops significantly, your debt-to-income ratio goes up or your home’s value decreases, you may find that you’re ineligible for a refinance. Should this happen, you’ll be stuck with the ARM and whatever rate it resets to after the fixed period – a rate that won’t always adjust in your favor.

The Bottom Line: Is An Adjustable-Rate Mortgage Right For You?

Adjustable-rate mortgages typically offer low-interest rates upfront for the first few years of your loan. Under the terms of an ARM, your interest rate can fluctuate with the market after your initial introductory period, causing monthly mortgage payments to go up or down once adjustment periods kick in.

That said, there are several reasons that an ARM might make good financial sense for you. For instance, if you’re planning to sell your home or refinance before rates change, or if you’re looking to save more money now, but expecting your income to increase in later years, an ARM might make sense. Under any circumstance, just be aware: Mortgage payments can increase significantly once the adjustment period kicks in.

Interested in applying for an ARM, or one of the many other types of home loan options that you can pick from? Get started now and apply with Rocket Mortgage^® today.