If you’re like most homebuyers, you probably already know what a mortgage is and whether you’ll need one. However, most people don’t realize that there are actually two options when it comes to home loans: adjustable-rate mortgages and fixed-rate mortgages.
The differences between the two are both nuanced and complicated, making it difficult to know which mortgage option is the best for your situation. On top of that, the initial terms of an adjustable-rate mortgage (ARM) can make it look particularly appealing at first glance . . . but does that mean it makes the most sense over the course of a mortgage’s typical 30-year term?
What Is an Adjustable-Rate Mortgage (ARM)?
Most homebuyers are familiar with fixed-rate mortgages, where the interest rate is locked in (“fixed”) and stays the same for the full term of the home loan. By contrast, an adjustable-rate mortgage’s interest rate will fluctuate throughout the term of the loan.
Most ARMs can be divided into two interest-rate periods. The mortgage starts in what’s known as the introductory period, sometimes referred to as the “teaser period.” During the introductory period, the interest rate is fixed for a set number of years and doesn’t change. This introductory interest rate is usually low compared to fixed-rate mortgages, making the ARM initially appealing to homebuyers shopping for a home loan.
However, after the introductory period ends, the ARM enters what is called the adjustable period. During the adjustable period, the interest rate will fluctuate based on the terms of the mortgage and can increase or decrease depending on what’s happening in the housing market.
How frequently the interest rate changes during the adjustable period is known as the rate of adjustment. The naming conventions of adjustable-rate mortgages indicate both the length of the introductory period and the rate of adjustment.
ARMs are usually referred to with two numbers separated by a slash (e.g., 3/6 or 3/1). The first number is the introductory period in years. The second number indicates the rate of adjustment.
So, a 3/6 ARM would have an introductory fixed rate for three years. Then the ARM would enter the adjustable period with a rate of adjustment of every six months. Similarly, a 3/1 ARM would have an introductory fixed rate for three years. Then the ARM would enter the adjustable period with a rate of adjustment of once per year.
ARM Terms to Know
Understanding how adjustable-rate mortgages work requires understanding some additional terms and how they interact with each other.
The index rate is the benchmark rate that is used to determine an ARM’s interest rate during the adjustable period. The Prime Rate and Secured Overnight Financing Rate (SOFR) are the rates most commonly used as index rates for ARMs. These rates will increase or decrease depending on the economy and the housing market.
The margin is an additional fixed amount added to the index rate that is charged to the borrower. For example, if an ARM has a margin of 3% and the index rate is currently at 4%, the borrower will have to make payments at a 7% interest rate (index rate + margin = ARM interest rate) until the next time the ARM’s interest rate adjusts. The index rate could increase or decrease, but the margin added to it will always be the same fixed percentage.
Adjustable-rate mortgages can also have caps on how much the interest rate can increase over time. There are three types of ARM caps:
- Periodic rate caps limit how much an adjustable-rate mortgage’s interest rate can increase year to year.
- Lifetime rate caps limit how much an adjustable-rate mortgage’s interest rate can increase over the loan’s full term.
- Payment Caps put a maximum limit on the amount the monthly mortgage payment can reach.
Payment Caps and Negative Amortization in Adjustable-Rate Mortgages
While rate caps are a good thing for borrowers as they put a limit on how much an adjustable interest rate can increase the monthly payment, payment caps can sometimes lead to something called negative amortization.
With normal amortization in a mortgage loan, a large portion of your monthly payment goes toward paying the interest on the loan, with the remainder going toward the loan’s principal, property tax, and homeowners insurance. As time passes, the proportion of your payment that goes toward interest decreases and instead pays off more of the loan’s principal, increasing the rate at which you gain home equity.
In negative amortization, the interest on the loan has increased so much that the monthly payment doesn’t adequately pay off the interest that’s accumulated because the payment cap doesn’t allow the monthly payment to increase enough to cover the full interest amount. This remaining interest is then added to the loan’s balance. This means that even though the borrower makes their full payment each month, the amount they owe on the loan actually increases because their payment is less than the interest accumulation.
Negative amortization doesn’t happen with every ARM as not all ARMs have payment caps. If you are considering an ARM, it’s imperative to understand all of the caps included and whether the potential for a negative amortization situation exists.
Types of Adjustable-Rate Mortgages
Adjustable-rate mortgages come in three different types, and they all work differently. Always make certain you fully understand the specifics of an ARM when evaluating it.
Hybrid Adjustable-Rate Mortgages
Hybrids are the most common form of ARM and are largely what’s been described in this article so far. In a hybrid ARM, there is an introductory fixed period followed by an adjustable period with a specified rate of adjustment for the rest of the loan’s term.
The length of the introductory period and the rate of adjustment are usually indicated by the numbers used to refer to the loan (e.g., 3/6, 5/1, 7/6, etc.).
Interest-Only Adjustable-Rate Mortgages
With an interest-only ARM, there is a set number of years at the beginning of the home loan where the borrower is only required to pay interest (and no principal). These can lead to a very low monthly payment during the interest-only portion of the mortgage, which can be advantageous if the borrower needs to spend money on home furnishings or renovations and repairs.
The downside to an interest-only ARM is that the borrower builds no home equity during the interest-only period. Additionally, the monthly payments after the interest-only period ends are likely to be substantially higher than a comparable mortgage, as the borrower must pay down the principal on the loan over a shorter period of time, in addition to the remaining interest.
Payment-Option Adjustable-Rate Mortgages
In a payment-option ARM, the borrower has different payment options to choose from. While these options vary, the most common options include paying both interest and principal, paying only interest, and paying a minimum amount due.
While it’s good to have options, paying only interest and paying a minimum amount (that might not even cover all the interest) can be a bit like kicking a problem down the road. The loan’s principal and interest will need to be paid before the term of the loan, so taking advantage of payment options too frequently can lead to unavoidably high payments later in the mortgage’s term.
Adjustable-Rate Mortgage or Fixed-Rate Mortgage?
When most people think of a mortgage loan, they likely think of a fixed-rate mortgage. You go into the home loan knowing what your interest rate is going to be for the duration of the loan, which makes the monthly mortgage payment easy to factor into the monthly budget payment. If mortgage rates decrease in the future, you still have the option to refinance into a lower rate.
By contrast, adjustable-rate mortgages are not so predictable. An ARM can look very appealing with a low fixed introductory period, but it’s not easy to predict the interest rate fluctuations once the mortgage enters its adjustable period. It’s difficult to know what your financial situation will be like ten years from now, and it’s equally difficult to know what interest rates will be like in ten years. This can make it very difficult to factor an ARM into a budget, especially if you have a tight budget.
Fixed-rate mortgages are great because they are predictable and stable. Adjustable-rate mortgages are not. In the end, you shouldn’t choose an ARM because the payments during the introductory period are appealingly low. Instead, you should only choose an ARM over a fixed-rate mortgage if you have a plan for how you’ll handle the mortgage payment once the fixed introductory period ends.
For example, ARMs can be great for investment properties that you plan to fix up and sell before the end of the introductory period. Likewise, if mortgage rates drop before the end of the ARM’s introductory period, you can always refinance into a fixed-rate mortgage. This can allow you to benefit from the low introductory ARM rate for a few years (perhaps while you invest in renovating your new home) and then secure a fixed-rate mortgage for the long term once mortgage rates look more appealing.
Is an Adjustable-Rate Mortgage the Right Choice?
In the end, an adjustable-rate mortgage is definitely not for everyone. There is a reason why fixed-rate mortgages are the standard. However, in the right situation, an ARM can be a good choice, but the borrower needs to fully understand how the ARM works and how their payments will change over time.
An ARM can potentially save you money, but an ARM can also leave you in a difficult financial situation if you aren’t prepared. When considering an adjustable-rate mortgage, ask a lot of questions and get all the information you need.
A mortgage loan originator from Hancock Whitney can help you determine if an ARM could be a good option for you. And if it isn’t, we can also help you get the ideal fixed-rate mortgage for your financial situation and future goals. Contact our mortgage team today to get started on your homebuyer’s journey.
