What Is an Adjustable-Rate Mortgage and How Do They Work?

How does an adjustable-rate mortgage work?

An adjustable-rate mortgage, also known as a variable-rate mortgage, has an interest rate that can change. Typically, an ARM’s interest rate stays fixed for a set amount of time and then adjusts periodically at a predetermined frequency. The adjusted interest rates may be lower or higher than the original interest rate, which will affect your monthly mortgage payment.

Every mortgage has an amortization schedule. This is a schedule showing how much of the monthly payment is interest and how much is principal. In most cases, as the mortgage is paid off over time, the payments cover more of the principal amount on the loan. There are certain ARM loan options that can lead to negative amortization, like an interest-only or payment-option ARM, meaning the amount you owe goes up over time.

Adjustable-rate mortgages vs. fixed-rate mortgages

A fixed-rate mortgage’s interest rate stays the same for the life of the loan. With an ARM, the interest rate is usually fixed initially, but it eventually changes to a variable interest rate for the rest of the loan term. ARMs also have lower starting interest rates than fixed-rate mortgages.

» LEARN MORE: Fixed vs. variable loans: Which is better for you?

Types of adjustable-rate mortgages

There are three main types of adjustable-rate mortgages:

Hybrid ARMs

Hybrid ARMs have a fixed-term interest rate for a period of time, followed by interest-rate adjustments at set intervals after the initial fixed term ends. A hybrid ARM is shown in numerical values that represent the initial fixed-rate term, followed by the schedule of how often the interest rate will reset. For example, a 5/1 ARM means that the loan will have a fixed interest rate for the first five years and will adjust every year after.

Payment-option ARMs

Payment-option ARMs allow you to choose different payment options each month. For example, you can choose an interest-only payment or you can choose to make a minimum payment that doesn’t cover the interest. With the second option, you might end up with negative amortization, which means the amount you’ll owe goes up over time. This is the most risky type of ARM, and it’s rarely offered today.

Interest-only ARMs

Interest-only ARMs have monthly payments that only cover the interest rate for an introductory period. After a set term, which usually ranges from a few months to a few years, the monthly payment will adjust so that you pay the mortgage off by the end of the loan term. This means you can expect a significant increase in monthly payments after the interest-only period ends.

Pros and cons of adjustable-rate mortgages

Here are some pros and cons of adjustable-rate mortgages:

Common terms for adjustable-rate mortgages

These are some of the most common terms to understand:

Adjustment period

An ARM’s adjustment period is the time between rate changes. For example, a loan with rate adjustments each year would be a one-year ARM.

After an ARM’s initial interest rate ends, the index and margin are combined to form your new interest rate.

Index and margin

An ARM’s interest rate is based on the index and margin. The index is a variable rate that’s calculated based on market conditions, while the margin is a number of percentage points set by the lender. Lenders calculate the margin based on your financial situation, and it usually stays steady throughout the life of the mortgage. After an ARM’s initial interest rate ends, the index and margin are combined to form your new interest rate.

Interest Caps

An interest cap is a limit on the amount an interest rate can increase initially and over time. There is an adjustment-rate cap limiting the increases during each adjustment period as well as a lifetime cap that limits how much the interest rate can rise over the life of the loan.

» MORE: Interest rate cap: what it means for ARMs

Is an adjustable-rate mortgage right for you?

There are many reasons you might choose an ARM over a fixed-rate mortgage. Here are just a few:

You don’t plan to live in the house long term

An ARM could work well for you if there’s a chance you may move or can pay off the loan before the rate adjusts. If you plan to own your home for a long time, though, you’ll need to plan accordingly and be prepared for a rate increase.

You want a lower interest rate now

If your income is low, it may seem better to have a lower starting rate and higher payments in the future, especially if you think your income will increase in the future. Either way, consider if you’ll be able to afford your monthly payments if the interest rate increases.

You think rates will decrease over time

Some people choose an ARM if fixed rates are higher than average and they expect rates to decrease over time.

You want to build equity faster

ARMs can help you build equity faster than other types of mortgages. This is because more of your payment is going toward the principal instead of interest.

FAQ

Bottom line

Adjustable-rate mortgages have low introductory interest rates, which are usually lower than market interest rates. This can help you build equity faster, as more of your monthly payment goes to paying down the principal loan amount. They also could be a good choice for you if you plan to own your home short term.

Still, ARM payments will fluctuate, which makes budgeting and planning for the future more complicated. That’s why many people prefer fixed-rate mortgages’ predictable payments. Before choosing an ARM, research different types of mortgage loans that might work for you and get estimates from several different mortgage lenders before making a final decision.