Is an Adjustable-Rate Mortgage (ARM) Right for Me?

Whether you’re buying a home or refinancing an existing mortgage, you have options when you apply for a home loan. You can and should obtain quotes from multiple lenders to make sure you have an affordable interest rate. You’ll also need to consider the terms of your mortgage loan and how they’ll impact you in the long run. Here at Addition Financial, we spend a lot of time talking to our members about mortgages and how they work. One of the questions we hear a lot is this:

“Should I get an adjustable-rate mortgage?”

The short answer to that question is maybe. There are some circumstances where getting an adjustable-rate mortgage makes sense—as well as many where the better choice is a fixed-rate mortgage. Here’s what you need to know as you decide if an adjustable-rate mortgage is right for you.

Table of Contents
  1. How do adjustable-rate mortgages work?
  2. What are the benefits of an ARM?
  3. What are the risks of an ARM?
  4. When is getting an ARM advantageous?
  5. What is the ARM application process?

How do adjustable-rate mortgages work?

Let’s start with an adjustable-rate mortgage definition. Adjustable-rate mortgages, commonly referred to as ARMs, have some unique features that you should understand before you apply for one. The most important thing to know is that with an ARM, your interest rate is subject to change after an initial period of six months to ten years, depending on the terms of your loan. You may have an interest rate during the initial period that’s lower than what you would see with a fixed-rate mortgage, but after the initial period of your home loan the rate may fluctuate.

How long is the initial period of an ARM?

The terms of an adjustable-rate mortgage are described with two numbers. The 5/1 ARM is the most popular. The 5 indicates the length of the initial period in years, and the 1 indicates how often the interest rate may be adjusted after the initial period ends. With a 5/1 ARM, you would have five years at the initial interest rate, after which your rate may be adjusted once a year.

Sometimes, the change period is shorter than a year. For example, some lenders, like Addition Financial, offer a 5/6 ARM, which means that after an initial 5-year period, your interest rate is subject to change every six months. 

How will my interest rate change with an ARM?

Interest rate fluctuations are a legitimate concern with ARMs, so let’s talk about how they work and whether there’s any way to predict how much interest you’ll pay in the long term.

Some lenders include interest caps in their ARM loan agreements, and these can make it a bit easier to plan for future interest increases. There are three caps that may come into play:

  1. Initial cap. This cap limits how much your interest rate can be increased at the end of the initial period.
  2. Period cap. This cap limits the increase that you get in each adjustment period.
  3. Lifetime cap. This cap sets a lifetime limit on increases, but you should keep in mind that lifetime caps sometimes exclude the first increase after the initial period.

One example of an interest rate cap structure would be a 5/2/5. This would limit the initial increase to 5% and each periodic increase to no more than 2%. The lifetime cap in this situation would not apply to the initial period, so your actual maximum increase would be 10%.

It’s not always the case, but there is a possibility that you could end up with a decreased rate if the market allows for it. Some lenders use a carryover that allows them to hold or increase a rate even if the index rate has declined if a periodic cap has prevented them from increasing the rate based on the market.

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What are the benefits of an ARM?

Here are some benefits to getting an adjustable-rate mortgage:

  • Favorable for applicants with lower credit scores. The initial rate will always be the available rate posted. Applicants with lower credit scores may have higher initial fixed-rate mortgage rates, deeming the ARM the less expensive option.
  • Lower monthly payments. Because adjustable mortgage rates are lower at the outset, your monthly payments with an ARM will also be lower at first.
  • Afford a larger/more expensive home. With a lower monthly mortgage payment comes the possibility that you may be able to afford a larger or more expensive home with an ARM than you could with a fixed-rate mortgage.
  • Interest rate decreases may occur. Although some ARMs have floor rates that limit how far interest rates can fall and some, as noted above, have carryovers, there is a possibility that your interest rate and monthly payment could decrease in response to market changes.
  • Caps provide some protection. Getting an ARM with initial, periodic and lifetime caps on increases can mitigate some of the risks associated with rate increases.

These benefits are what lead some people to apply for ARMs instead of fixed-rate mortgages.

What are the risks of an ARM?

We would be remiss if we didn’t explain some of the risks of choosing an adjustable-rate mortgage:

  • Increases are likely to occur. Because ARMs typically have low initial rates, it’s a virtual certainty that your interest rate will increase after the initial period and may continue to increase throughout the term of the loan.
  • Monthly payments may increase and strain your budget. Increased interest rates translate directly to higher monthly payments. A lot of homeowners who have ARMs find that their budgets are strained after the initial period.
  • Monthly payments may be unpredictable. People who prefer predictability may not like the uncertainty that comes with an ARM, since it can be difficult to plan when you don’t know what your rates will do in the future.
  • Terms may be difficult to understand. The terms of an ARM are more complicated than the terms for a fixed-rate mortgage, and that can be stressful.

You’ll need to weigh these risks against the advantages of an ARM before you decide–and make sure you have the financial wherewithal to cope with increases in your ARM rate and monthly payments.

When is getting an ARM advantageous?

Despite the risks associated with ARMs, there are times when choosing an ARM may be advantageous. Here are some scenarios to consider.

You’re unsure of where you'd like to settle

There are many situations where someone may be purchasing a property where they intend to live for no more than five to seven years. Such as buying a starter home or moving to an area that you're unsure about. These people benefit from an ARM because they can sell the property before the initial period ends. That means they can save with a lower monthly payment and get out of the mortgage before the rates increase.

You’re buying investment property to flip

Anybody who’s interested in buying investment properties that they don’t plan to hold in the long term may want to consider an ARM instead of a fixed-rate mortgage. They may also want to consider an interest-only mortgage (a type of ARM) because they can sell the house for a profit before they pay any of the principal.

Interest rates are high

When interest rates are high, you may not be able to afford the monthly payments with a fixed-rate mortgage. In that situation, it may make sense to opt for an adjustable-rate mortgage, build equity, and refinance your mortgage as a fixed-rate loan after interest rates drop.

5/6 arm

What is the ARM application process?

Here’s a run-down of the ARM application process to help you prepare if you decide to apply for an adjustable-rate mortgage. When shopping around, you may find that different lenders may have their own qualifications, however, you’ll find that, in general, adjustable-rate mortgage qualifications are as follows:

  • A credit score of at least 620 (580 for FHA adjustable-rate mortgages)
  • A debt-to-income ratio no higher than 50%
  • A down payment of at least 5% (3.5% for FHA loans)
  • Maximum loan-to-value ratio of 95%

You may want to consider making a large down payment if you can, since doing so will decrease your monthly payments. You’ll need to provide other documentation just as you would with a fixed-rate mortgage, including proof of employment and income. Here are the steps in the ARM application process:

  1. Review your credit and correct errors. It’s always a good idea to request copies of your credit reports from Equifax, Experian and TransUnion and notify them of any errors that could be negatively impacting your credit score.
  2. Research lenders. We suggest doing some preliminary research on lenders before you decide where to apply.
  3. Complete the mortgage application. You’ll be required to provide information about yourself and any co-borrowers. You’ll also be asked for supporting documentation.
  4. Review your Loan Estimate. Your Loan Estimate will include important disclosures from your lender, and with an ARM, you’ll want to pay special attention to what it says about interest rates and caps.
  5. Go through the underwriting process. There may not be much for you to do during the underwriting process, but make sure not to do anything that may impact your credit score, such as making a major purchase or applying for a new credit card. Respond to any inquiries as quickly as possible to avoid delays.
  6. Close on your loan. The final step is to close on your loan and sign the paperwork.

These steps are the same as they would be with a fixed-rate mortgage. The only real difference is that you’ll need to pay extra attention to what your loan agreement says about interest rates, increases and caps.

Get an affordable mortgage with Addition Financial

Getting an adjustable-rate mortgage may be the right thing to do if you’re not buying your forever home, plan to buy an investment property to flip or want to take advantage of lower rates at a time when interest rates are high. The information we’ve included here will help you understand the benefits and risks of ARMs and make the best decision for your circumstances.

Are you looking for a financing option that offers more flexibility? Addition Financial has the mortgage you need! Click here to learn about our 5/6 adjustable-rate mortgage and begin the application process today.

The content provided here is not legal, tax, accounting, financial or investment advice. Please consult with legal, tax, accounting, financial or investment professionals based on your specific needs or questions you may have. We do not make any guarantees as to accuracy or completeness of this information, do not support any third-party companies, products, or services described here, and take no liability or legal obligations for your use of this information.