When interest rates are high, many homebuyers turn to adjustable-rate mortgages, better known as ARMs. That’s because these mortgages typically come with initial interest rates that are lower than what they’d get when applying for a standard 30-year or 15-year fixed-rate mortgage.
Those lower initial rates mean lower monthly mortgage payments. That’s the good news. The downside? Those lower initial rates don’t last forever.
The fixed period: An ARM comes in two parts: First, there’s the fixed period. This typically lasts for five to seven years. During these years, an ARM’s interest rate remains fixed, meaning it doesn’t change. This is why ARMs are beneficial during times of higher mortgage interest rates. If you qualify for an ARM, you’ll typically get a lower initial interest rate that will remain in place for five to seven years.
The adjustable period: ARMs get more complicated after this fixed period ends. That’s when they enter their adjustable period, the years in which the loan’s interest rate can change, usually once a year.
Depending on what economic index an ARM is tied to, its interest rate will usually increase once a year. That could prove challenging to homeowners who didn’t budget for the higher mortgage payment that comes when their ARM’s interest rate adjusts upward. that’s why you must make sure that you can afford your loan’s monthly payment even after its interest rate rises.
Here’s how an ARM works: Say you take out a 5/1 ARM. During the first five years of your loan, your interest rate — typically one that is lower than what you’d get with a fixed-rate mortgage — won’t change for five years. After this period ends, your interest rate will adjust once a year. Though it doesn’t have to, you can generally expect your rate to rise during this time.
There are some protections for homeowners, though. Most ARMs come with caps on how much interest rates can rise after their fixed period ends. An ARM’s initial adjustment cap states how much its interest rate can rise initially after the fixed period ends. This cap will vary, but typically interest rates will rise no more than five percentage points after the initial fixed period ends.
ARMs often come with a lifetime adjustment cap too. This cap represents the maximum amount that your rate can rise during the entire lifespan of your loan. Typically, this cap comes in at 5%. This means that your ARM’s interest rate can never be more than five percentage points higher than its initial rate. If your ARM had an initial rate of 3.5%, then the highest that rate could climb to with a 5% lifetime cap would be 8.5%.
It’s important to know these different caps when taking out an ARM. They can help you determine if there’s room in your household budget for your mortgage payments after they increase during your ARM’s adjustable period.
The refinancing move: You can also consider refinancing out of an ARM to a fixed-rate mortgage before your loan reaches its adjustable period. That would give you the benefit of a low initial interest rate without the uncertainty that comes with a rate that can rise or fall each year. Make sure you have enough equity in your home, though. You’ll usually need at least 20% equity to qualify for a refinance.
Considering an ARM? Get qualified financial advice to see if it’s right for you.