Fixed-rate mortgages are the most popular mortgages on the market, but they may not be right for every homebuyer in every situation.
Adjustable-rate mortgage loans (ARMs) offer options for borrowers who would benefit from a different approach to financing their mortgage due to specific life events or financial situations.
News alert! Look before you leap.
Don’t jump into an adjustable-rate loan without doing a deep dive into the intricacies of this loan product. The reason? ARMs can be risky. They are complicated loans with specific features and terms that will impact the amount of your mortgage payment over the life of the loan.
To help explain the terms of ARMs and to weigh the pros and cons, we have invited Richie Helali, loan officer and sales lead at HomeLight Home Loans to provide us with a roadmap through the idiosyncrasies of adjustable-rate loans. Let’s see what’s ahead!
What is an adjustable-rate mortgage?
An adjustable-rate mortgage is a loan where the interest rate changes or adjusts over the life of the loan.
Typically, there’s an introductory interest rate for a set period of time that’s lower than the current average interest rate, which means your mortgage payments will likely be lower during the first few years.
A typical ARM loan would include a three-, five-, or seven-year introductory rate, with the rate then adjusting every year thereafter, depending on the market rate. These are known as 3/1, 5/1 or 7/1 loans.
“After those first five or seven years, the rate will adjust up or down with market conditions,” Helali explains.
“Typically, the interest rate of an adjustable-rate loan is going to adjust once a year on the anniversary.”
What do the ARM numbers mean?
The first number of an ARM loan indicates the number of years that the loan will have the introductory rate. With a 5/1 ARM, the initial interest rate is applicable for five years. With a 7/1 ARM, the initial interest rate would run for seven years.
The second number tells you how often the rate will be adjusted after the introductory period. With a 5/1 ARM, the interest rate will adjust once a year on the anniversary of the loan. A 5/5 ARM would adjust every five years.
The most popular ARM loans are 5/1 ARMs, according to Investopedia.
How does the rate adjustment work?
To understand how the rate adjustment would work for a specific loan offering, here are five questions you should ask your loan officer.
Frequency: How often will my rate change?
For most ARM loans, the interest rate will change once a year on the anniversary of the mortgage.
For instance, if you have a 5/1 ARM, your interest rate will adjust in your 61st month of your mortgage and every 12 months thereafter. You will be notified what your new interest rate will be for the coming year and how your payment will change at least 60 days prior to the first adjusted payment is due.
Index: How will you decide what my new interest rate will be?
Your lender will determine your new interest rate based on a specific index they tie your mortgage to.
Margin: How is my interest rate calculated against the index?
As part of the ARM agreement, the lender will let you know what your margin will be — for instance, 1%, 1.5%, or 2%. This margin will be added to the index rate. Here is an example:
- 2021 – your original 5/1 ARM rate was 3%
- 2026 – the index rate on your loan anniversary is 3%
- Your agreed-upon margin is 1%
- Your new interest rate would be 3 + 1 = 4%
Remember, this 1% raise is for one year. Each year, the rate will adjust again, according to market conditions and the terms of your loan.
Here is a chart showing how the margin influences your total payments over time. In this example, we are comparing the difference between a 0.5% margin and a 0.75% margin.
|30 Year, 5/1 ARM, $360,000||0.5% annual margin||0.75% annual margin|
|Starting interest rate||3%||3%|
|Interest rate cap||12%||12%|
|First monthly payment||$1,517.77||$1,517.77|
|Maximum monthly payment||$2,796.08||$3,024.43|
|Rate remains fixed for||60 months||60 months|
|Periods between adjustments||12 months||12 months|
This shows how even a small margin adjustment can increase the cost of the loan, especially the amount of interest you will pay over the life of the loan.
It is also helpful to plug in your specific numbers on an ARM mortgage calculator to understand the long-term costs of this type of mortgage loan.
Caps: How much can my interest rate increase?
Most ARM loan agreements include caps or limits on the amount your interest rate or payment can increase each year.
For instance, it may indicate that the interest rate cannot increase more than 2%, even if the index suddenly jumps from 3% to 6%. The agreement may also include a cap on how high your monthly payment can increase.
Ceiling: Is there a maximum interest rate that I can be charged?
Your lender will also provide you with a maximum interest rate in your agreement. This is generally calculated against the current interest rate.
For instance, if the current rate is 4%, the lender could cap your interest rate increases at 5% over the life of the loan. In this calculation, your ceiling rate would be 9%, and your interest rate could never go higher than that.
“The expectation with an ARM loan, however, is that the borrower is unlikely to wait that long to refinance,” Helali said.
“You’re probably going to refinance prior to actually getting to a ceiling that high, especially since, currently, we’re not expecting the rates to get to that high point. But it could happen!”
Helali recommends reviewing the pros and cons with your loan originator and asking what they would do if they were in your shoes.
“People think based on movies such as the Big Short that a loan officer makes more money if they sell you an adjustable mortgage,” he said. “That’s not true anymore. A loan officer is not compensated based on the program somebody chooses. We are compensated based on closing the transaction with a happy client.”
How does an ARM compare to a fixed-rate mortgage?
A fixed-rate mortgage simply means that the interest rate stays the same over the life of the loan.
“If somebody has a mortgage today of $2,500 a month, it’s going to be the same 10 years from now or even 25 years from now,” explains Helali (though note that property taxes and insurance rates can go up over the years). “Over time, the cost of it is actually going to feel less with inflation.”
Typically, fixed-rate mortgages are offered for specific terms or number of years, usually 10, 15, or 30 years.
The 30-year fixed rate mortgage is by far the most popular of all mortgage products. The reason most homebuyers gravitate to this loan is because your mortgage payment (i.e. the principal and interest) never changes, and paying the mortgage off over 30 years keeps the payments manageable.
“Personally, I always choose a 30-year fixed, because I want that assurance of knowing what my payment is going to be,” Helali adds.
Here is a chart showing typical terms and costs for a $360,000 5/1 ARM, as compared to the same loan with a fixed-rate mortgage.
|30 Year, $360,000||5/1 ARM||Fixed-rate mortgage|
|Starting interest rate||3%||4%|
|Interest rate cap||12%||4%|
|First monthly payment||$1,517||$1,719|
|Maximum monthly payment||$2,796||$1,719|
|Rate remains fixed for||60 months (5 years)||30 years|
|Periods between adjustments||12 months||N/A|
|Annual expected adjustment||0.5%||N/A|
The downside of an ARM loan is that an ARM is constantly adjusting to a different rate and could be costly over the life of the loan. However, depending on the terms of your loan, you do have the option of refinancing your loan to move it into a fixed-rate mortgage before the adjustments begin.
Three situations in which a homebuyer would benefit from an ARM
Here are some situations where it may make economic sense for a borrower to consider an ARM loan.
Moving within initial rate period
If you know you will be moving within the initial interest rate period, perhaps because you plan to fix up and buy up, or because you are likely to be relocated because of your job, an ARM loan has the advantage of a low initial payment.
If you are planning to sell before the adjustment period, then you won’t have to worry about future adjustments. If you plan to use an ARM and sell in a few years, be sure to ask about the loan’s prepayment penalty (more on that soon).
Need a lower monthly payment
An ARM loan may help if, for instance, you know your income is going to be substantially higher in the future.
For example, if your partner is in college, you may know that in a few years with both of you working, your income will be more than adequate to cover a larger monthly payment.
Interest rates are heading downward
If interest rates are currently high, but heading downward due to economic trends, you might anticipate that your adjustment rate could stay the same or even drop in the future.
You may decide it is worth the gamble knowing that you can always refinance into a fixed-rate mortgage if the anticipated drop does not occur. But keep in mind you’ll have to pay closing costs on the refinance, so that’s something to budget for if you decide to go this route.
The pros and cons of an adjustable-rate loan
Major financial decisions like choosing a mortgage loan are highly dependent on each person’s specific needs. That’s why it is so important to consider the following benefits and downsides of the ARM loan in light of your situation.
If you plan to sell your home or refinance, or if you are going to relocate for work in a few years, the lower initial payments of an ARM loan may be a financially wise choice.
If you are working on an advanced degree or on track for a promotion at work, then an ARM may benefit your more modest lifestyle now, knowing you can afford higher payments or refinance later.
While there can and most likely will be increases in your payments in the future, caps and ceilings are typically built into the loan contract to protect you from overly dramatic increases in the short term.
An ARM loan is unpredictable. You can’t know what your payments are going to be in the future.
“When it reaches that adjustment period, you are not going to have a lot of time to prepare,” Helali says.
“About two months before that first new payment is due, you get hit with a notice that your payments are going from $2,000 a month to $2,700 a month.”
Also, an ARM loan can cost a lot more over the life of the loan, as compared to a fixed-rate loan.
And finally, some ARM loans could come with a prepayment penalty, making it more expensive to refinance in the first few years of the loan.
A prepayment penalty is an additional fee that some lenders charge if you pay off all or part of your mortgage loan before the scheduled term.
In 2014, the Consumer Financial Protection Bureau (CFPB) established strict laws around the use of prepayment penalties.
Typically, you will only be charged a prepayment penalty when you pay off the entire mortgage balance — for example, you sold your home or are refinancing your mortgage — and that payoff happens within a specific number of years, usually within the first three years of owning your house or carrying the loan. In some cases, prepayment penalties could apply when you pay off a substantial chunk of your mortgage at one time.
If you make additional principal payments on your mortgage in small chunks, then prepayment penalties do not normally apply, but the CFPB advises that you check with your lender to make sure it is OK.
Some loans are forbidden to have prepayment penalties. If a lender does include a prepayment penalty on your loan, there are restrictions:
- The prepayment penalty can only run for the first three years of the mortgage
- There are caps on the amount of a penalty a lender can levy
- Lenders are required to offer an alternative loan that does not include a prepayment penalty
- Lenders must disclose what the penalties will be
The critical risk to an ARM loan is that there is no way to know what will happen in the market in five years’ time. ARM loans were very popular in the mid-2000s during the housing boom, but they fell out of favor after the Great Recession.
When the real estate market tanked in 2008, many borrowers with ARM loans found themselves “underwater” on their mortgages.
As real estate values crashed, a borrower who purchased a home for $600,000 now discovered that their home appraised at only $400,000. When they attempted to refinance the $530,000 they owed on an ARM loan into a fixed-rate mortgage, the lenders were unwilling to approve a loan on a home that appraised for far less than what was owed.
5 things to consider when opting for an ARM loan
The Great Recession is an extreme example. But it is also a cautionary tale — a reminder of how important it is to consider every aspect of your finances and situation before making a decision.
Here are some questions to ask yourself.
How long do I plan to stay in the home?
If you are planning to move within the introductory period, then an ARM loan may be a good option.
Is my income likely to increase, decrease, or stay the same?
If your income is likely to stay consistent, then a fixed-rate loan may be a better option because it is easier to budget for long-term.
Where are interest rates headed?
If you enjoy studying the markets and follow financial information regularly, then you may be able to make an informed decision both now and in the future as your ARM resets.
Otherwise, it may be good to meet with a financial adviser to discuss the current rates and predicted market fluctuations.
If my mortgage payment went up, would I still be able to afford it?
You may decide an ARM makes sense until you pay off your student loans or finish your car payments, knowing you will be able to meet the increased obligations of a larger mortgage payment in the future.
What does my lender or financial adviser think?
Listen to the professionals, Helali advises.
“There’s information available online, which is great, and it lays out the different options available,” he notes. “But there’s no graph that specifically says, ‘This is what someone in your exact shoes should do.’ That’s why it’s so important to talk to a loan officer so they can help you determine what is best for your specific circumstances.”
No matter which mortgage product you are leaning toward, we invite you to discuss all of your options with your real estate agent who may then assist you with identifying a loan officer, mortgage broker, or financial advisor who can help guide you to a final decision, ARM or no ARM.
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