What is an Adjustable Rate Mortgage?

An adjustable-rate mortgage (ARM) provides an alternative option to the traditional fixed-rate mortgage. In an adjustable-rate mortgage, your initial interest rate will be fixed for a set number of years. After the fixed-rate period has ended, your rate and monthly mortgage payment can fluctuate. ARM loans are typically structured in one of the following formats:

• 3/1
• 5/1
• 7/1
• 10/1

The first number of each ARM format represents your fixed interest period. For instance, if you chose a 3/1 adjustable-rate mortgage, your interest rate would be locked in for three years.

The “1” indicates how often your rate can change after the fixed period ends. In all the aforementioned ARM types, your rate would be adjusted annually for the remaining life of the loan.

Some of the most notable advantages of adjustable-rate mortgages are:

Lower Payments and Initial Interest Rate

By opting for an ARM, you can access great interest rates. ARMs become especially appealing when general interest rates rise. This is because ARMs generally have interest rates significantly lower than those available for fixed-rate loans. Lower interest rates mean lower monthly payments for you.

When your fixed-rate period ends, your rates will be adjusted. However, that does not necessarily mean the rates will go up. If interest rates fall, your rate will be dropped to make it more competitive with current offers.

Keep in mind that your rates can go up as well. If you are reaching the end of your fixed rate period and current rates are higher than your existing ARM rate, your lender will likely increase the interest on your mortgage.

If you plan to move, it might be a good idea to sell your home before your rate lock is over. On the other hand, if you want to stay put, consider refinancing to get a better rate.

Pay House Principal Down Faster

If your interest rate is lower, a higher percentage of every payment will be going toward the principal of your loan. This means that you can pay down your principal faster and build equity in your home.

Remember, the monthly mortgage payment on your ARM loan is already lower than a traditional fixed-rate mortgage would have been. Therefore, you can roll some of those savings back into your home.

You could pay extra on your ARM loan to reduce your principal balance even faster. ARM loans carry no prepayment penalty, which means that you will not incur any hidden fees if you pay off your loan altogether.

Buy More House

Like most buyers, you probably set your home purchasing budget based on the monthly payment amount, not the total price of the property. If you have been exploring ways to buy more houses, an ARM may be the ideal solution.

With an ARM loan, you can waste less money on initial interest charges and invest more into your principal mortgage payment. Even a single percentage point of interest can influence your monthly payment by $200-$300.

Potential for a Lower Payment After the Fixed Period

After your fixed rate period has ended, your lender will reevaluate your ARM loan and adjust your rate. If the rates are higher than your current rate, they will raise it. The good news is that if interest rates fall, your rate can drop with it. This means that your monthly payment will drop, too.

For instance, let’s say that you buy a home with a 3/1 ARM, and your initial rate is 4%. When you bought your home, rates for traditional mortgages were 6%. Therefore, you saved about 2% of interest per year during the 3-year fixed period. 

At the end of your 3-year fixed-rate period, interest rates fell to 3%. In this scenario, your lender would drop your rate to be more competitive with current rates, which means you would save even more money.

How to Pick the Right ARM?

When choosing an ARM, the two factors you should consider are the initial interest rate and the fixed rate period. The shorter the fixed rate period you choose, the better your overall rate will be. For instance, your rate for a 3/1 ARM will likely be better than the initial rate for a 7/1 ARM.

However, if you are not sure if you plan to stay in the home, opting for a longer fixed rate period might be the better move for you. This gives you more time to decide whether the house is still your dream home or if you are due for an upgrade.