An adjustable rate mortgage (ARM) is a home loan where the interest rate adjusts over time. Adjustable rate mortgages usually start with an interest rate lower than fixed rate mortgages, but that initial low interest rate doesn’t last forever. Because the rate is not set in stone, it is called an adjustable rate mortgage.
While an adjustable rate mortgage can sometimes feel like a gamble since the interest rate you’re paying can go up or down, an ARM is a good option for specific situations.
An adjustable rate mortgage is a good idea if you:
- Plan on paying more than your payment early on
- Will only be living in your home for a short period of time
- Live in a high interest rate market
- Are close to retirement
If your situation is a good idea for an adjustable rate mortgage, but a fixed rate mortgage may also be an option, let’s compare them so you can make the right decision.
The Differences and Similarities of Adjustable and Fixed Rate Mortgages
|Fixed Rate Mortgage||Adjustable Rate Mortgage|
|Interest rate does not change||X|
|Interest rate can change over time||X|
|Lower initial interest rates||X|
|Interest rate caps||X|
|Interest only options||X|
|Makes it easier to budget||X|
|Easier to qualify for If you have a high debt to income ratio||X|
|Uses your credit score to qualify you||X||X|
|Monthly payment can change||X|
|Needs a 3% down payment||X|
|Needs a 5% down payment||X|
|Can’t be customized||X|
|Simple to understand||X|
|No prepayment penalties||X||X|
|Good for long-term homeowners||X|
|Good for short-term homeowners||X|
|Typically a 30-year loan||X||X|
|Most popular type of financing||X|
The main difference between a fixed rate mortgage and an adjustable rate mortgage is the interest rate which starts when you take the loan. For fixed rate mortgages, the interest rate is set when you take out the loan and will not change regardless of the length of the loan; whereas the interest rate does change with adjustable rate mortgages.
Fixed rate loans are a better idea than ARMs if the market you’re in changes frequently. By choosing the fixed rate you can lock in a good deal. Adjustable rate mortgages tend to be better than fixed rates if you plan to refinance, or the market may give you more favorable rates over the duration of the loan. And there are numerous types of adjustable rate mortgages.
The Types of Adjustable Rate Mortgages
There are three types of adjustable rate mortgages:
- Interest only
- Payment option
Hybrid adjustable rate mortgages
Hybrid adjustable rate mortgages are a mix of fixed-rate and adjustable rate financing. They are usually called a 3/1 ARM, 5/1 ARM, 7/1 ARM and 10/1 ARM. The first number stands for how many years you pay the fixed interest rate before the adjustable rate starts. The second number is how often that rate will change after the fixed rate period ends.
A 3/1 ARM means you will pay a fixed rate interest for three years and then your rate will adjust every year after that until your loan is paid off. With a 10/1 ARM, your interest rate won’t adjust for 10 years.
Interest only adjustable rate mortgages
With an interest only adjustable rate mortgage, you pay only the interest for a specified time. After that, you pay both the principal and interest normally for a period of 3 to 10 years.
Remember that interest only payments will be significantly less than the principal + interest payments, so plan on your payments going up dramatically.
Payment option adjustable rate mortgages
This adjustable rate mortgage allows you to choose between these three options every month:
- Making a traditional principal and interest payment
- Paying an interest-only payment
- A limited payment is made that is less than the interest due that month (the unpaid interest and principal is then added to the amount you owe)
Payment option adjustable rate mortgages have a recalculation period that will usually happen every five years.
Your decision on what kind of mortgage loan you should take out should be guided by your budget, housing needs, and how much risk you are willing to accept. An adjustable rate mortgage doesn’t have to be scary now that you know the pros and cons, as well as when it makes sense to take one.