Buying a home is one of the biggest financial decisions you’ll ever make, and choosing the right mortgage can have a long-term impact on your budget. One option that often confuses homebuyers is the Adjustable-Rate Mortgage (ARM). Unlike a fixed-rate mortgage, where your interest rate stays the same, an ARM offers a lower initial rate that can change over time.
But is an ARM a smart choice, or could it lead to unexpected payment increases in the future? In this blog, we’ll break down how ARMs work, their pros and cons, and whether they’re the right fit for you. Plus, we’ll use simple examples to make it easy to understand, even if you’re new to home buying. Let’s dive in!
What is an Adjustable-Rate Mortgage (ARM)?
An Adjustable-Rate Mortgage (ARM) is a type of home loan where the interest rate changes over time. Unlike a fixed-rate mortgage, which has the same interest rate for the entire loan term, an ARM starts with a fixed interest rate for a few years and then adjusts periodically based on market conditions.
How Does an Adjustable-Rate Mortgage (ARM) Work?
Fixed-Rate Period – In the beginning, an ARM offers a fixed interest rate for a set number of years. This period is typically 3, 5, 7, or 10 years, during which your monthly mortgage payment remains the same.
Adjustment Period – After the fixed period ends, the interest rate adjusts periodically (usually every year) based on an economic index. This means your monthly payment could go up or down depending on market rates.
Adjustable-Rate Mortgage Loan Naming Example:
You’ll often see ARMs written as 5/1 ARM, 7/1 ARM, or 10/1 ARM. Here’s what these numbers mean:
- 5/1 ARM – The interest rate is fixed for 5 years, then adjusts once per year after that.
- 7/1 ARM – The interest rate is fixed for 7 years, then adjusts once per year afterward.
- 10/1 ARM – The interest rate is fixed for 10 years, then adjusts once per year moving forward.
Example of an ARM in Action
Let’s say you take out a 5/1 ARM with an initial interest rate of 4% on a $300,000 loan.
- Years 1-5: Your monthly payment is $1,432 (fixed at 4%).
- Year 6: The fixed period ends, and your rate adjusts to 6% based on market conditions. Your new monthly payment increases to $1,798.
- Year 7 and Beyond: The rate continues to adjust annually, meaning your payments could go up or down depending on interest rate trends.
This unpredictability is why some homebuyers prefer fixed-rate mortgages, while others take advantage of the lower initial rates of an ARM, especially if they plan to sell or refinance before the rate adjusts.
Understanding how an ARM works can help you decide if it’s the right mortgage option for your financial goals.
Now, let’s dive into the pros and cons of an ARM.
Pros of an Adjustable-Rate Mortgage (ARM)
An Adjustable-Rate Mortgage (ARM) can be a smart financial choice for certain homebuyers, depending on their goals and how long they plan to stay in their home. Here are the main advantages of choosing an ARM:
1. Lower Initial Interest Rate
One of the biggest benefits of an ARM is the lower starting interest rate compared to a fixed-rate mortgage. This means your monthly payments will be lower during the initial fixed-rate period, helping you save money.
Example:
- A 30-year fixed-rate mortgage at 7% might have a $2,000 monthly payment.
- A 5/1 ARM starting at 5% could have a $1,750 monthly payment.
- That’s a $250 per month savings for the first five years.
2. More Affordable in the Short Term
Since ARMs start with lower interest rates, they are a good option for buyers who plan to sell or refinance within a few years. You can take advantage of the lower payments before the adjustable period begins.
Example:
- You take a 7/1 ARM, meaning your rate is fixed for 7 years.
- If you sell your home in year 6, you never reach the adjustable period and benefit from the lower initial rate.
3. Potential for Lower Payments if Interest Rates Drop
Unlike fixed-rate mortgages, which stay the same no matter what, an ARM can adjust downward if interest rates fall. This means you could end up paying less over time without having to refinance.
4. Easier Qualification for Higher Loan Amounts
Because ARMs have lower starting payments, lenders may approve you for a larger loan compared to a fixed-rate mortgage. This means you might afford a more expensive home than you would with a fixed-rate loan.
Example:
- With a fixed-rate mortgage, you qualify for a $350,000 loan.
- With an ARM, due to the lower initial payments, you might qualify for a $400,000 loan.
5. Ideal for Short-Term Homeowners
If you know you’ll be moving in a few years due to work, lifestyle changes, or investment purposes, an ARM can be a great way to save money on interest while you own the home.
When an ARM Makes Sense?
An ARM could be a good choice if:
- You plan to sell or refinance before the adjustable period starts.
- You can handle a potential rate increase in the future.
- You expect interest rates to drop, reducing future payments.
- You want to qualify for a larger loan to buy a better home.
While ARMs offer great advantages, they also come with risks, especially when interest rates rise. Next, let’s look at the cons of an Adjustable-Rate Mortgage and when you might want to avoid it.
Cons of an Adjustable-Rate Mortgage (ARM)
While an Adjustable-Rate Mortgage (ARM) can offer lower initial payments, it also comes with risks that homebuyers should carefully consider. Here are the main drawbacks of choosing an ARM:
1. Interest Rates Can Increase After the Fixed Period
The biggest risk with an ARM is that after the fixed-rate period ends, your interest rate can go up. This means your monthly payments could increase significantly, making it harder to budget for housing costs.
Example:
- You start with a 5/1 ARM at 4% interest, with a $1,500 monthly payment.
- After five years, your rate adjusts to 7%, and your new monthly payment jumps to $2,000.
- That’s a $500 increase per month, which might strain your finances.
2. Rate Adjustments Are Unpredictable
Your mortgage rate is tied to an economic index, which means you cannot predict how much it will change after the fixed period. If interest rates rise significantly, your payments could become unaffordable.
Example:
- You start with a 7/1 ARM at 3.5% interest.
- After seven years, rates increase sharply, and your new rate jumps to 8%.
- Your monthly payment rises by hundreds of dollars, causing financial stress.
3. Long-Term Costs May Be Higher
Even though ARMs start with lower interest rates, if rates rise over time, you could end up paying more in total interest compared to a fixed-rate mortgage.
Example:
- A 30-year fixed-rate mortgage at 6.5% means predictable payments for the entire loan term.
- A 5/1 ARM starting at 4.5% could increase to 7% or more, resulting in higher total interest paid over the life of the loan.
4. Harder to Budget for Future Payments
With a fixed-rate mortgage, you always know how much your monthly payment will be. But with an ARM, your payments can change every year after the fixed period, making it difficult to plan for future expenses.
5. Could Lead to Financial Stress or Foreclosure
If your payments increase too much and you can’t afford them, you risk losing your home. This is why it’s important to only choose an ARM if you’re financially prepared for possible payment hikes.
When an ARM Might Not Be the Best Choice
An ARM may not be ideal if:
- You plan to stay in your home long-term and want predictable payments.
- You can’t afford higher payments if rates increase.
- You don’t want to worry about market fluctuations.
- You are on a fixed income and need stable housing costs.
While ARMs offer lower initial rates, they come with uncertainty and potential financial risks. If you plan to move or refinance before the adjustable period, an ARM could save you money. But if you want stability and long-term predictability, a fixed-rate mortgage might be the safer choice.
Before choosing an ARM, analyze your finances, future plans, and risk tolerance to make the best decision for your home purchase.
Final Thoughts
Adjustable-Rate Mortgages offer lower initial rates and can be a great short-term option for some borrowers. However, they come with the risk of rising rates and higher payments down the road. If you’re considering an ARM, make sure you understand how it works and whether it fits your financial situation.
If you’re unsure, talking to a mortgage advisor can help you decide if an ARM or a fixed-rate mortgage is better for your home-buying goals.
Would you choose an ARM or a fixed-rate mortgage? Let us know in the comments!