What Is an Adjustable-Rate Mortgage?

An adjustable-rate mortgage (ARM) is a type of home loan with an interest rate that fluctuates over the life of the loan. ARMs begin with a fixed-rate period, which can range from six months to 10 years, but is typically for three, five, or 10 years. Generally, the initial fixed-rate period features a lower rate than a similar fixed-rate mortgage. Once the fixed-rate period ends, the ARM switches to a variable rate for the remainder of the loan term, known as the adjustment period.

Pros of an Adjustable-Rate Mortgage

Lower Initial Payments

ARMs typically offer lower interest rates during the fixed-interest period than similar 30-year fixed-rate mortgages. These reduced rates may result in lower mortgage payments that make homebuying more affordable.

Flexibility for Short-Term Borrowers

If you only plan to keep your property for a few years, an adjustable-rate mortgage may help you keep your borrowing costs lower before you sell the property. However, be aware of potential prepayment penalties that could offset any savings.

Potential for Lower Interest Rates

Mortgage rates are typically tied to an index and adjust periodically. If interest rates are high during the fixed-rate period, they may begin to fall once your adjustment period begins, potentially lowering your interest rate and monthly payments.

Cons of an Adjustable-Rate Mortgage

Monthly Payment Can Increase

Although ARMs may come with an interest rate adjustment cap and a maximum adjustment limit, your mortgage rate and monthly payments can increase. If you’re not prepared for it, a higher payment could strain your budget.

May Require a Larger Down Payment

The minimum down payment on a conventional ARM is typically higher than with other types of mortgages. By contrast, some conventional fixed-rate mortgages require as little as a 5% down payment.

Refinancing Can Be Costly

Refinancing an ARM to a fixed-rate mortgage can incur significant closing costs, which can run into the tens of thousands of dollars, depending on the size of your loan.

Adjustable-Rate Mortgage vs. Fixed-Rate Mortgage

When comparing an ARM with a fixed-rate mortgage, always do the math. Working out precisely how much each loan will cost you in the initial fixed-rate period—and how much you could pay if interest rates skyrocket over the years—can help you understand short-term savings versus long-term costs.

For example, if you’re buying a $500,000 home with a 20% down payment, you need a $400,000 mortgage. Comparing a 30-year fixed-rate loan and a 5/1 ARM using their average rates from August 2023—7.18% and 6.20%, respectively—can illustrate potential savings and costs.

Is an ARM a Good Idea?

An ARM may be worth considering if you’re looking for a lower-cost alternative to a fixed-rate mortgage to purchase a home. Besides the initial money you could save, a lower interest rate and payment could make it easier to qualify for a mortgage.

However, if you don’t want to worry about potential rate and payment increases, a fixed-rate mortgage provides you with a set-it-and-forget-it option. This predictability can provide you with peace of mind, knowing what your mortgage payment will be for the next 30 years.

Should You Refinance an ARM to a Fixed-Rate Mortgage?

If you do choose an ARM, you can refinance to a fixed-rate loan after your initial rate expires. But refinancing generally comes with closing costs and fees, and you’ll need to watch interest rates so you can time your refinancing when rates are low.

The closing costs on a mortgage can range from 2% to 6% of the loan amount. If you don’t anticipate keeping the home for the long term, refinancing may not be worth the cost. However, if you plan to keep your property for the long haul, locking in a new rate could reduce your risk.

Good Credit Can Help You Obtain a Low Mortgage Rate

Homeowners struggling to qualify for fixed-rate mortgages may find the lower rates and monthly payments on adjustable-rate mortgages attractive. The initial fixed-rate period of ARMs can make buying a home more affordable for these buyers. By contrast, fixed-rate mortgages offer stability and predictability that risk-averse buyers may prefer.

If you’re considering both types of loans, seek out different lenders to compare rates and monthly payments in a variety of scenarios. Carefully review any loan agreement, making sure you understand all of its terms before proceeding.

Contact O1ne Mortgage for Your Mortgage Needs

At O1ne Mortgage, we understand that choosing the right mortgage can be a daunting task. Whether you’re considering an adjustable-rate mortgage or a fixed-rate mortgage, our team of experts is here to help you make an informed decision. Call us today at 213-732-3074 for personalized mortgage advice and to explore the best options for your financial situation.