When you are buying a new home or refinancing your existing home loan, it’s likely you’ll be introduced to a wide variety of mortgage types. While it may seem logical for some to select a mortgage based on what friends or family have chosen, it’s actually most important to weigh whether or not a mortgage fits your individual lifestyle and future housing plans.
A big decision you will be making is whether to choose a fixed-rate or an adjustable-rate mortgage (ARM). Though the majority of mortgage shoppers choose a fixed-rate loan because of its long-term stability, there are many pros to choosing an ARM for the right borrower.
For example, an ARM is often attractive to mobile and career-driven borrowers, those planning to make an addition to the household in the near future, or essentially anyone anticipating that they will want to transition to a new home in the next ten years. The main reason for this is the relatively low short-term introductory rate and payment an ARM can offer, which is often comparatively lower than fixed-rate loans.
So, what is an ARM exactly and how does it differ from a fixed-rate mortgage? We’re going to break down the adjustable-rate mortgage so you can decide if it’s the best loan choice for your home purchase or refinance.
The Adjustable-Rate Mortgage, Defined
The basic definition of an adjustable-rate mortgage (ARM) is a home loan with an interest rate that adjusts over time to reflect market conditions. An important key structure of the ARM is the initial introductory period, which typically has a low fixed rate committed to the loan for that set period, which in most cases will be five, seven or ten years. In general, the shorter the initial period is, the more favorable the rate offered.
Once that initial fixed-rate period is completed, the rate will henceforth be calculated based on the index — the current benchmark interest rate — plus a set margin amount. How often it is calculated, referred to as an adjustment period, can depend on the lender. For example, if the adjustment period is six months, then the new rate is calculated every six months.
This new rate can increase or decrease a homeowner’s monthly payments — which may at first glance seem a little risky to more conservative borrowers. Keep in mind, however, that most ARMs have limits on how much the interest rate or the monthly payment can be changed at the end of each adjustment period or over the life of the loan. In addition, when market conditions keep interest rates low, ARM borrowers benefit. Before signing on the dotted line, borrowers evaluating an ARM option should always consider how long they intend to stay in the home, as well as the initial rate, initial rate period, and the adjustment period.
Why Choose an ARM?
There are several potential advantages and possibilities to consider with an ARM for the right homeowner or homebuyer:
- Get a comparatively lower rate when you buy or refinance, fixed for the entirety of the introductory period (5-10 years)
- Use your equity to get cash through a refinance (Cash-Out Refinance) while maintaining a low monthly payment
- Afford a new or larger home sooner with a lower initial payment
- Pay less for your mortgage in a home you plan to move from in the next ten years
- Consider refinancing into a fixed-rate mortgage once the initial period ends (Some lenders, such as Pennymac, will even allow you to keep the same term you left your ARM with on your new fixed-rate loan — e.g., 21-year, 23-year, 25-year, etc.)
- Refinance out of an ARM at any time; no prepayment penalties
Like any other loan, the initial agreement spells out the terms, so be sure you read through everything carefully and have a clear understanding of all the details before you make a decision.
How Do Adjustable-Rate Mortgages Work?
To understand how all of these elements work together, let’s imagine that a lender is offering a customer a 5/6 SOFR ARM at 3.25% with 2/1/5 caps. See this table below for a brief explanation, and we’ll go into more specific detail below.
|ARM Element||Element Name||Element Example|
| 5/6 |
(the 5 in 5/6)
|Initial rate and period|| |
The initial rate on the loan is 3.250% for the first five years.
(the 6 in 5/6)
|Adjustment period|| |
After 5 years, the interest rate can adjust every six months.
|Market index (SOFR, in this example)||Rate adjustment|| |
The rate adjustment in our example loan is based on changes in the common (SOFR) index.
|2/1/5 caps||Initial rate adjustment cap|| |
The first number is the maximum percent change allowed for the first adjustment period.
For this first adjustment period, the interest rate can never adjust higher than 2% above or below the initial rate
|2/1/5 caps|| |
Subsequent rate adjustment cap
The second number is the maximum adjustment allowed each time the rate adjusts. This maximum applies to both increases and decreases in the rate
The interest rate can never adjust more than 1% above or below the previous rate.
|2/1/5 caps|| |
Lifetime rate cap
The third number is the maximum rate increase allowed overall in the lifetime of the loan.
The interest rate can never go higher than 5% above the initial rate (3.25% + 5% = 8.25%).
What Is the Initial Rate and Period?
The interest rate that you secure when you first get an adjustable-rate mortgage is called the initial rate. In most cases, the lender will offer a fixed rate for an introductory period before the adjustment period begins. Pennymac, for example, offers adjustable-rate loans with 5, 7, and 10-year initial fixed-rate introductory periods. This standard ARM offers a period of predictability and comparable savings for the initial period, making it a desirable option for certain borrowers.
What Is the Adjustment Period?
The adjustment period is the length of time that your interest rate will remain unchanged once the initial period is over, as well as in between each new adjustment. For example, an ARM that specifies a recalculation of your mortgage interest rate at the end of each year has an adjustment period of one year. During this time, your interest rate will remain the same, but it may change from year to year depending on variations in the market index.
How Are Rate Adjustments Made?
Although the specific details vary depending on the lender and your loan terms, interest rate adjustments often reflect the changes in the market index your loan uses. Many loans today are based on the SOFR Index Averages (New York Fed). If the market index increases, your interest rate will also likely increase. On the other hand, if the market changes favorably, your rate might decrease accordingly.
Other common indexes:
- Monthly Treasury Average
- Federal Funds Rate
- Fannie Mae 30/60
- The Prime Rate
- 10-yr Treasury Security
- Discount Rate
Interest Rates Are Usually Capped
Many ARMs specify the maximum rate increase or decrease allowed for each adjustment and the highest your interest rate can go over the life of the loan.
In our example, the 5/6 ARM has 2/1/5 caps. The “2” in the first position means that at the first adjustment, the interest rate cannot go up or down more than 2 percent. The “1” represents the limit a rate can go up or down in every adjustment after the first one. From the second adjustment until the end of the loan, the annual adjustment can’t go up or down more than 1 percent compared to each preceding adjustment period. The last number, the “5,” represents the lifetime ceiling adjustment. This means the interest rate will never increase higher than 5% from the initial, introductory rate for the life of the loan.
ARMs: Risk vs. Reward
Because of the unpredictable nature of an ARM during the term after the introductory period compared to a fixed-rate mortgage, you should be prepared for the possibility of a higher interest rate at some point in the future. However, the initial rate for an ARM is often relatively low, so this type of loan can be a good fit in the following cases:
A brief period of ownership is anticipated. If you plan to stay in your home for a relatively shorter time with plans to move to a different location or larger home in the next 5-10 years, you can take advantage of the lower initial rate offered with an ARM that you wouldn’t get with a fixed-rate loan. In our example loan above, a buyer planning on staying in the home for just five years or less may not be concerned about the adjustment period since they don’t plan to own the home at the time the adjustment would begin.
You plan on refinancing your loan before the completion of the introductory period. Lenders like Pennymac have no prepayment penalties or restrictions on refinancing out of an ARM. Some borrowers may choose to take advantage of the ultra-low introductory rate of an ARM, and then refinance into a fixed-rate loan by the completion of that initial period to enjoy the stability of a fixed rate for the remainder of the loan. Pennymac also offers flexible terms on fixed-rate loans, meaning you can conceivably keep the loan’s end date you originally set forth in your ARM, should you prefer.
There are reliable expectations of an income increase in the near future or long-term budgeting has been set aside for higher rates, if necessary. If your career trajectory is likely to include a predictable increase in income, you can rest assured you can handle any increase in market rates in the future. Even if you can already afford a higher initial rate now, an ARM allows you to save during the initial rate period so you can apply those savings in other ways. In our example, if the borrower is able to afford the monthly payment at 8.25%, they can enjoy the monthly payment savings from the lower initial rate, putting the money to other good uses.
Risk tolerance. If you believe that the market is likely to shift in favor of lower interest rates, an ARM is a good choice. But also be absolutely certain you would be able to pay the full interest rate should the market fluctuate upward.
If you would like to read more about ARMs, the Federal Reserve has provided the Consumer Handbook on Adjustable Rate Mortgages (ARM) as a reference tool, which includes a checklist to help you compare mortgages.
If you are considering an ARM and would like to figure out if it’s a great choice for you or not, a Pennymac loan expert can help walk you through your possibilities. Call to explore your options today.