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An adjustable-rate mortgage can be beneficial if you plan on selling or refinancing before the loan's rate changes, but there are risks. Your plans could change, the monthly mortgage payment could rise and become unaffordable and you may need a bigger down payment to qualify for the mortgage.
Adjustable-rate mortgages (ARMs) generally come with introductory interest rates that are lower than their fixed-rate counterparts, but the rate may rise in the future. Here's what to know about an adjustable-rate mortgage, and how to decide if it's the best option for you.
Pros of an Adjustable-Rate Mortgage
The 30-year fixed-rate mortgage is the most common type of home loan, but ARMs are growing in popularity as home prices rise, according to the National Association of Realtors. Here are a few reasons you might benefit from an adjustable-rate mortgage.
Lower Initial Payments
ARMs usually offer initial interest rates 0.25% to 0.1% lower than 30-year fixed-rate conventional loans. That rate will remain for six months to 10 years, depending on the type of ARM you choose—though it's most likely you'll find ARMs with fixed periods of three, five or 10 years. After that, the rate could change once a year or every six months in line with market conditions.
That lower intro rate could reduce your monthly mortgage payment by thousands of dollars during the fixed period. For this reason, ARMs are particularly beneficial for first-time homebuyers or borrowers on tight budgets.
Learn more: Compare Current ARM Rates
Flexibility
If you're planning to sell or refinance within a few years, an ARM could keep your mortgage costs lower while you're in the home. If you sell or refinance before rates change, you could save a significant amount on interest.
When considering this strategy, check whether there's a prepayment penalty on the loan. Most mortgages don't carry prepayment penalties, but if they do, the penalty may apply if you pay off the balance due to a sale or refinance in the first three to five years of holding the mortgage.
Possible Interest Rate Drop
ARMs have variable rates that are usually tied to a benchmark, such as the Secured Overnight Financing Rate (SOFR) or the prime rate. That means your annual percentage rate (APR), which takes into account both interest and fees, may adjust up or down after the initial fixed term. While you should always plan for your rate and monthly payment to climb so you're not caught off guard, they could also fall. If interest rates are high during your fixed period, they may drop by the time your loan begins adjusting.
Rate Caps
Most ARMs cap how much your rate can rise, which helps if you're concerned about dramatic increases. Check the loan documents for caps on the first adjustment, each adjustment thereafter and the lifetime rate to see how your mortgage payment might be affected.
A periodic cap limits the amount the rate can increase from one adjustment period to the next, while a lifetime cap limits the total amount the mortgage rate can increase over the introductory rate. Most commonly, the lifetime cap is 5 percent. The loan may also come with a lifetime limit on the amount the rate could decrease.
Lenders must specify the highest payment possible over the course of the term in your loan estimate. This is a document the lender is required to send you within a maximum of three days after your mortgage application.
Cons of an Adjustable-Rate Mortgage
An adjustable-rate mortgage can help you save money in some limited circumstances. But it comes with large caveats.
Monthly Payment Can Increase
When the adjustable period begins, your mortgage rate and monthly payment may go up. While rate caps help prevent your rate from spiking too much, the higher payment can still put sudden pressure on your budget. If you're not prepared, that added cost could make it harder to afford your mortgage and manage your other expenses.
It's also difficult to know what your finances will look like in five, 10 or 20 years, and how a potentially larger mortgage payment could affect them. You may be dealing with unexpected job loss, a career change or caregiving for a child or older relative, for example, which would limit flexibility in your budget.
May Require a Larger Down Payment
A conventional ARM may require a bigger down payment than other types of mortgages. The minimum down payment could range from 5% to 10% or more, depending on your lender, desired loan amount and financial factors like your credit, payment history and debt-to-income ratio (DTI). By contrast, some conventional fixed-rate mortgages require as little as 3% down.
You could qualify for a 0% down payment ARM if you have exceptionally good credit and meet the lender's requirements, though you may have to pay private mortgage insurance. Or you can go with a government-backed mortgage, such as a Federal Housing Administration (FHA) ARM, which requires only 3.5% down if your credit score is at least 580. Veterans Affairs (VA) ARMs don't require a down payment.
Refinancing Can Be Costly
If current interest rates are high, you may be tempted to choose an adjustable-rate mortgage to take advantage of its lower introductory rate and refinance later on. Closing costs on a refinance, however, can range from 2% to 6% of the loan amount, which might end up being more than you'd save during an ARM's intro period. If you refinance to another ARM, your rate could eventually increase, too, further eroding your savings.
Plans Don't Always Work Out
Market conditions change, and if the housing market slows, it could be hard to sell your home when you planned. If you planned to refinance, interest rates may have increased to the point where that no longer makes sense. Finally, you may decide you'd rather stay in your home if your life circumstances change instead of moving as expected, leading to higher mortgage payments.
Should You Get an Adjustable-Rate Mortgage?
Choosing an ARM can be a savvy move, but it can also lead to headaches and a suddenly unaffordable mortgage. Here's when it is a good option, and when it's best avoided.
You Might Consider an ARM If:
- You have clear plans to stay in your home only for a few years. If you're reasonably sure you'll move within a few years, an ARM could help you save money while you're living in the home. For example, let's say you bought a $500,000 home with a 5/1 ARM at a 6.25% interest rate, and you made a down payment of 10%. You'd make monthly payments of $3,079 for the first five years. By contrast, a 30-year fixed-rate mortgage with a 6.75% rate on the same house would come with monthly payments of $3,227. Over five years, the ARM savings would amount to $8,880.
- You plan to refinance later. An ARM can help you get into a home now with a more affordable loan. Refinancing after the initial fixed period ends could help you save money in the loan's early years. Keep in mind, though, your lender may charge a prepayment penalty for refinancing before the adjustment period begins, and mortgage rates could also be higher when you're ready to refinance.
- You're buying during a high-rate environment. When interest rates are elevated, a lower initial rate and payment could help you qualify for a mortgage more easily. This strategy might make sense if you predict rates will drop and plan to refinance at that time.
You May Want to Avoid an ARM If:
- You want stability. If you're uncomfortable with unknowns, like how much your rate and mortgage payment could rise in the future, an ARM might not be worth it. You may prefer the predictability of a stable fixed-rate mortgage.
- The cost of refinancing outweighs the savings. Getting a lower-rate ARM now and refinancing later may help you save money—but not always. Closing costs on a refinance can be substantial, so you'll need to make sure the long-term savings outweigh the refinancing costs.
Alternatives to an Adjustable-Rate Mortgage
If you're not keen on crossing your fingers with an ARM, consider other mortgage options like these:
- Fixed-rate mortgage: With a fixed-rate mortgage, no matter which way interest rates fluctuate, you have the peace of mind of knowing your rate and payment amount will never change for the life of the loan. You won't benefit if rates drop, but you'll avoid an increase if they rise. You can also always refinance in the future if you want a lower rate.
- Government-backed mortgage: These loans often require minimal or no down payments and have more lenient qualifications. FHA loans allow borrowers to put as little as 3.5% down (though you'll pay mortgage insurance on an FHA loan no matter how large your down payment is). VA loans don't require a down payment or mortgage insurance for qualified borrowers. U.S. Department of Agriculture (USDA) loans offer 0% down for eligible rural buyers with low to moderate incomes.
Frequently Asked Questions
How Does an Adjustable-Rate Mortgage Work?
An adjustable-rate mortgage has an introductory fixed-rate period followed by a schedule of regular adjustments once or twice a year. It's most common to get an ARM with fixed-rate periods of five, seven or 10 years. Their rates can start off lower than fixed-rate mortgages, but there's always the risk that the rate could rise with market conditions.
How Is an Adjustable-Rate Mortgage Calculated?
The lender provides an introductory rate, and then when it adjusts, the lender combines the index and the margin to calculate your new rate. The index is an interest rate that reflects economic conditions, like the Secured Overnight Financing Rate (SOFR) or the prime rate. The margin is an extra amount added to the index, decided on by the lender.
Who Are Adjustable-Rate Mortgages Best For?
Adjustable-rate mortgages are best for borrowers who plan to move or refinance before the lower initial rate changes, or those who want to buy now but can't afford or qualify for a loan otherwise. In this situation, though, make sure you understand and are comfortable with the potential changes to your monthly payment as described in your loan agreement before moving forward.
Where Can I Get an Adjustable-Rate Mortgage?
ARMs are widely available from the same types of lenders that also offer fixed-rate mortgages: large, regional and community banks; credit unions; online lenders; and government programs. You can also work with a mortgage broker to find a lender, or search comparison marketplaces online.
The Bottom Line
An adjustable-rate mortgage could help you qualify for a mortgage, often with an initial rate lower than you'd find on a comparable fixed-rate loan. The potential savings during the fixed-rate period could make it more affordable to buy a home, as long as you're aware the rate may increase once that period ends.
You could also get a lower rate by putting down a larger down payment, lowering your DTI and boosting your credit profile. You can check your credit report and FICO® Score☉ Θ from Experian for free to discover any issues that may be harming your credit. If needed, take steps to improve your credit before applying for a new mortgage.