Shopping for a mortgage feels like learning an entirely new language of terms and acronyms. From LTVs to DTIs (front end and back end), cash reserves to credit scoring models, it’s overwhelming.
So when your loan officer asks if you’d prefer a fixed interest loan or an ARM, how do you respond?
Read on to learn everything you need to know about ARMs — adjustable-rate mortgages.
What Is an Adjustable-Rate Mortgage (ARM)?
An adjustable-rate mortgage is exactly what it sounds like: a mortgage where the interest rate changes over time. Contrast it against fixed-interest mortgages, where the rate stays constant for all 15-30 years of the loan term.
How ARM Interest Rates Work
Two related factors drive ARM interest rates up or down: benchmark indexes and margins.
When mortgage lenders issue an ARM, they set the interest rate based on a benchmark index. Two popular benchmarks include the Fed Funds Rate and the LIBOR (London Interbank Offered Rate). Both are baseline interest rates that banks often use when lending to one another.
Now, you aren’t as creditworthy as a bank, and lenders need to earn a profit margin on their loans. So they charge a margin on top of this low, baseline index rate.
For example, say you take out an ARM priced with a 4% margin over the LIBOR. If the LIBOR is 0.5%, you would pay interest at 4.5%.
Your loan’s interest rate doesn’t reset every single month. Instead, it typically resets once a year, although some ARMs reset less frequently.
When you first borrow an ARM, you typically get a certain number of years with a fixed interest rate.
Lenders offer this to sweeten the deal, tempting borrowers with a low interest rate for the first three to seven years of the loan. Once the interest rate switches over and starts adjusting, typically it jumps up.
That works out well for the lender, because they win whether you keep paying the higher interest rate or you refinance your mortgage for a lower one. Lenders earn money on up-front fees when you take out a new loan, including a refinance. And they earn a disproportionate amount of interest at the beginning of the loan, when more of each monthly payment goes toward interest rather than paying down your principal.
Lenders also prefer ARMs to fixed-interest loans because it keeps them earning market interest rates throughout the life of the loan. If interest rates go up, they get to charge more. They’re not stuck with the low interest rate you got when you first took out the loan.
When your loan officer pitches you an ARM, these loans typically come with two numbers, such as “5/1 ARM.” The first number indicates the number of years for the fixed-rate period, and the second indicates how often the interest rate adjusts after that. A 5/1 ARM comes with five years of a fixed interest rate, and thereafter the interest rate adjusts once each year.
Interest Rate Caps
Most adjustable-rate mortgages come with an interest rate cap, limiting how high the interest rate can rise. These payment caps protect you from skyrocketing interest rates causing your mortgage payment to multiply.
Often lenders put a 5% cap on ARM interest rates, so your rate can never go higher than five percentage points above the introductory rate. If you paid an introductory fixed rate of 4%, your interest rate would be capped at 9%. Even if the benchmark index plus your loan’s margin went higher, the lender couldn’t charge you more.
ARM vs. Fixed-Rate Mortgage
Fixed-rate loans come with a set interest rate for the entire life of the loan. It doesn’t matter how benchmark interest rates move in the coming decades. You pay the same interest rate until you’ve paid off your loan in full.
Lenders prefer to issue ARMs, to protect them from future interest rate movements. So they typically offer ARMs with a lower initial interest rate than they offer fixed-rate mortgages.
In an era of perpetually low interest rates, it usually makes more sense to take out a fixed-interest loan. There are a few exceptions, like if you plan to move before the initial fixed-rate period expires or you have bad credit and thus only qualify for an extremely high fixed interest rate. If you have bad credit, take the cheaper ARM for now, then spend the next five years improving your credit before refinancing for a lower fixed rate.
Types of ARMs
Not all adjustable-rate loans work the same way. Make sure you understand the variations in ARMs before committing to one.
Hybrid ARMs come with the introductory fixed-interest rate period, as outlined above. Most ARMs are hybrid ARMs. Remember that because lenders prefer ARMs, they offer the initial low fixed interest rate to sweeten the pot.
Interest-only loans are exactly what they sound like. You only pay the interest on the loan each month, rather than paying money toward your principal balance as well. You then pay back the entire principal balance at the end of the loan term.
For example, I lent $25,000 interest-only to a real estate investing couple at 10% interest. They pay me $2,500 per year in interest (10% of the loan balance). When they’re ready to pay me back in full, they’ll send me the initial $25,000 I lent them.
Interest-only ARMs work similarly, except the interest rate adjusts. This year, you might pay 5% interest, but if benchmark interest rates go up, so do your interest payments to the lender.
Interest-only loans are rare for homeowners. Most home loans are amortized, meaning you pay back a portion of the principal balance with each payment. In doing so, you pay down the principal balance over time.
Some ARMs allow you some flexibility in how much you pay each month. Those options include:
- Full Principal and Interest: You make a regular monthly payment that includes both interest and money toward your principal balance.
- Interest-Only: You only pay interest, as with a traditional interest-only ARM.
- Minimum: You pay so little that it doesn’t even cover interest. Think of this like credit card minimum payments, where you avoid late fees but you just dig yourself in deeper with interest.
As you can guess, payment-option ARMs give you a shovel for digging yourself into a hole of debt. Sure, you’d welcome the flexibility during lean months, but it’s all too easy to bury yourself in a mountain of interest.
When you make only the minimum payment, you end up paying interest on top of your interest. Think of it like compounding in reverse, where your interest spirals upward over time.
Negative Amortization ARM
While rare today, this type of mortgage works on the same principle as minimum payments outlined above. You pay nothing toward your principal balance, and don’t even pay enough interest to cover what you owe.
Lenders offered ARMs with an introductory period with negative amortization. This kept the initial monthly payments low. Then the payments would rise over time, so that borrowers eventually pay back the full interest and principal owed.
Lenders introduced these loans in the 1980s when interest rates were high and the expectation was that interest rates would drop in the future. In the 1990s, payment-option ARMs largely replaced negative amortization ARMs as a flexible option.
Should You Refinance an ARM?
Because the interest rate will likely jump once it starts adjusting, most borrowers plan to either sell their home or refinance their mortgage by that time.
But refinancing your mortgage comes with plenty of downsides.
To begin with, you can expect thousands of dollars in lender fees, title fees, and other closing costs.
Beyond those refinancing fees, your amortization schedule also resets. This means the bulk of each monthly payment goes toward interest instead of principal. The proportion of each payment going toward interest declines only gradually over the life of the loan, so that you pay off most of your principal balance in the last few years.
Lenders never want you to get to that point. They want to keep refinancing you indefinitely, to keep earning those new closing costs. They want to keep returning you to Square One in your amortization schedule.
It’s an endless cycle of debt, where they keep tempting you with cash from your home’s equity — and keep extending your debt horizon forever.
As a general rule, take out a fixed-interest loan if you plan to stay in your home indefinitely. If you plan to move around the time that your fixed-interest period ends, then consider an ARM. But remember that you risk a jump in your monthly payment if you don’t sell by that date.
Pros of Adjustable-Rate Mortgages
While many borrowers look askance at them, ARM loans make sense for some borrowers, some of the time.
Keep the following ARM advantages in mind as you shop for mortgages.
- Low Fixed-Interest Period. Lenders use low fixed interest rates in the initial fixed period to attract borrowers. Usually they charge a lower interest rate during this period than you’d pay for a fixed-interest mortgage. If you plan to sell or refinance your home before this initial period ends, ARMs can save you money.
- Interest Rate Caps. Even if interest rates rise, the lender limits how high your interest rate and monthly mortgage payment can rise.
- Lower Payments Possible. While not likely, it’s theoretically possible that your interest rate and monthly payment could go down if interest rates were to fall between now and when your fixed interest period ends.
- Subprime Borrowers Allowed. During the peak of the 2000’s housing frenzy, ARMs were largely considered a subprime mortgage product. Borrowers with weak credit could qualify for ARMs with an affordable monthly payment — until the fixed interest period ended, that is. You can debate whether people with bad credit should buy a house or rent, but ARMs do provide a gateway mortgage for buying a first home.
Cons of Adjustable-Rate Mortgages
These adjustable loans come with plenty of drawbacks. Make sure you understand them fully before buying a home with one.
- Higher Payments Likely. Lenders price the margin so that the borrower’s interest rate will almost certainly go up from the low introductory fixed rate. Even if benchmark rates go down slightly between now and when your rate starts adjusting, you’ll still probably pay a higher rate because lenders price in a wide margin once the adjustment period starts.
- Prepayment Penalties Possible. Some ARMs come with a prepayment penalty. This is a hefty fee that lenders charge if you pay the loan off early — typically within the first two to five years. If you plan on an ARM as a temporary loan to take advantage of the low initial interest rate and expect to pay it off before the rate starts adjusting, you could get hit with a penalty for doing so. Double-check whether a loan comes with a prepayment penalty before agreeing to it.
- Risk of Keeping the ARM. Just because you plan to sell or refinance the home before the interest rate starts adjusting doesn’t mean it will happen that way. You may decide to stay in the house after all, leaving you with the two bad options of refinancing or keeping your expensive ARM. And if your credit score drops, refinancing may be harder or more expensive than you think.
- Complexity. No one wants more complexity in their finances, especially with such a big monthly bill. Adjustable-rate mortgages can come with weird rules and costs that confuse even financially savvy borrowers. In fact, the very premise behind ARMs feels like a bait-and-switch. The lender lures you in with a low initial interest rate, knowing that after the intro period ends, they’ll either collect higher interest or juicy refinancing fees.
Adjustable-rate mortgages make for one more option as you shop around for loans. But they come with their fair share of risks and downsides, especially for borrowers without much financial savvy.
ARMs work best as temporary mortgage loans, but that very premise makes little sense. It takes years to build enough equity in your home to recover the closing costs of buying a home, and the second set of closing costs when you go to sell. If you only plan to stay in a home for just a few years, you’re probably better off renting rather than buying.
Enter the embrace of ARMs with both eyes open, if at all.