By Mike Yates CMB, AMP
SVP | Mortgage Sales Director | NMLS #: 533618
So, you’re thinking about an Adjustable-Rate Mortgage. Or maybe you’re not, but you’ve heard about ARMs and you’re curious if one might be a good fit for your home buying situation.
Let’s dive in and talk about what an Adjustable-Rate Mortgage is, how it works and when it may make sense to consider one.
But first, a couple of quick housekeeping terms you’ll need to know.
An Adjustable-Rate Mortgage is often called an ARM, and that’s what you’ll see throughout this blog. And a mortgage is simply a loan secured by a home, whether that’s a house, condo, townhouse manufactured home, etc. And just for fun, did you know the term 'mortgage' comes from an Old French term, “mort gage,” which quite literally means "dead pledge." In many ways, you are pledging your life, or at least 30 years (on average), to a mortgage. Doesn’t this give you warm fuzzies?
Now, let’s get back to business, all you ever wanted to know about ARMs and more.
An Adjustable-Rate Mortgage is a home loan that starts with a fixed interest rate for a set period of time. After that initial period ends, the rate may adjust periodically based on market conditions.
The biggest difference between an ARM and a fixed-rate mortgage is that a fixed-rate mortgage keeps the same interest rate for the life of the loan. With an ARM, the interest rate may increase or decrease after the initial fixed period ends. When the interest rate changes, the monthly principal and interest payment may change, too.
That doesn’t make an ARM better or worse than a fixed-rate mortgage. They’re simply different options that may make sense for different situations.
There are a few reasons.
The most impactful is that the rate on an ARM can be lower (up to 1% lower or more) than the 30-year fixed rate. Lower rates = lower payments and lower total interest paid. So, if you want a lower initial payment, plan to refinance before the fixed rate period ends, or are comfortable with variable payment, an ARM provides you flexibility.
You believe rates will decrease. When rates are high, an ARM may be worth considering because your rate can adjust with market trends. So, in a declining-rate market, an ARM rate may decrease over time, and you will benefit from the lower rate without having to pay expensive fees to refinance.
You may have run the numbers and determined that the savings from the ARM outweigh the comfort of the thirty-year fixed-rate loan. We’ll walk through an example together later.
Every ARM has two main phases.
During the initial fixed-rate period, the interest rate stays the same. After that period ends, the rate may adjust at set intervals based on the terms of the loan.
Most ARMs have a fixed-rate period of three, five, seven or ten years. In rare cases, fifteen years. Once that period ends, the rate starts to adjust every six months or once a year.
ARM loans are often displayed like this:
3/1, 5/1, 7/1 or 10/1
3/6, 5/6, 7/6 or 10/6
The first number tells you how many years the initial rate is fixed. The second number tells you how often the rate may adjust after that period.
For example, a 5/6 ARM has a fixed rate for the first five years. After that, the rate may adjust every six months. A 5/1 ARM is also fixed for five years, but it may adjust once a year after the fixed period ends.
Now let's get nerdy for a minute.
There are a few more terms you’ll want to know when considering an ARM.
Your ARM will be tied to an index. An index is a benchmark interest rate that reflects broader market conditions. Common indexes include the Secured Overnight Financing Rate, or SOFR, and the Constant Maturity Treasury rate, or CMT.
The index is the part of the formula that may change as market conditions change. Your loan documents will tell you which index your ARM follows.
What is likely more important than what index your ARM is tied to is the margin. The margin is the spread, or what is added to your index to come up with your new rate once your fixed-rate period ends.
Here’s an example:
You’re buying a home and you select a 5/6 ARM. Your rate is 6.25% for the first five years of the loan and then adjusts every six months after that. When your loan starts to adjust, your new rate will be your index + margin rounded to the nearest 1/8th of a percent.
Every ARM has caps that limit how much the interest rate can change. Your loan terms will spell out the specific caps that apply. Let's stay with this example of a 5/6 ARM that is now starting to adjust.
The initial rate cap limits how much your rate can change the first time it adjusts, so in this example, your 61st payment. In case you’re not a math major, 12 payments a year × 5 years = 60 payments. Typically, initial rate caps range from 2% to 5%.
The annual cap limits how much the rate can change at each subsequent adjustment. Typically, this is around 2%.
Finally, the lifetime cap limits how much your rate can increase over the life of the loan. Typically, this is around 5%.
The loan may also have a floor, which is the lowest the rate can reach, and a ceiling, which is the highest.
Alright, let’s do the math.
It’s OK, this won’t hurt too much.
Let’s keep going with our 5/6 ARM rate at 6.25% and add that you are purchasing a home for $400,000 and borrowing $300,000. When you apply for a mortgage, the Mortgage Loan Officer also lets you know that the 30-year fixed-rate mortgage is at 6.75%.
The half-percent difference may not sound like much, but locked in for 30 years, and you don’t have to worry about rate changes. Sounds like a no-brainer, right? Well, not so fast.
Going with the ARM means you will owe less in five years, plus it saves you $98.64 per month, which is $1,183.68 per year, and over the initial five-year fixed period, it would save you $5,918.40.
That’s real money, but the savings still may not be worth the uncertainty for every borrower. For some people, the comfort and predictability of a 30-year fixed-rate mortgage will have more value, and that’s completely OK.
Here’s where the math gets a little more interesting.
After five years, the remaining principal balance on the ARM in our example would be approximately $280,012. The balance on the fixed-rate loan would be approximately $281,627.
Now let’s say you choose the 5/6 ARM but make the same $1,946 payment as the 30-year fixed mortgage. That can help you build equity faster.
After five years, the remaining balance on the ARM would be approximately $273,085.
Of course, another option is to use the monthly difference for other priorities, such as building an emergency fund, paying down higher-interest debt or saving for home improvements. The important thing is to understand your options and decide what best supports your financial goals.
No one knows exactly where interest rates will be five, seven or ten years from now. That’s why it’s important to look at multiple scenarios before choosing an ARM.
If you really want to do more math, an experienced Mortgage Loan Officer can show you what happens in years 6, 7, and so on if rates go up, down, or stay the same.
If ARMs can be a useful option, why have so many people heard negative things about them? Your Uncle Bob and your parents have told you the 30-year fixed rate is the only option and to never get an ARM. They’re just looking out for you.
Some of that reputation comes from products offered before the financial crisis, including payment-option ARMs. Borrowers to choose from several monthly payment options, including payments that did not cover all of the interest owed.
When the payment didn’t cover the interest, the unpaid amount could be added to the loan balance. This is called negative amortization, and it could cause the balance to grow rather than decline.
A standard ARM with an initial fixed period, a defined adjustment schedule and disclosed rate caps is structured differently. That’s why it’s important to evaluate the terms of the specific loan rather than relying on the ARM label alone.
OK, that was a lot. You still with me?
Here’s the reality...most people don't keep their mortgages for 30 years. In fact, hardly anyone does. They may move, refinance, pay off the loan early or adjust their plans as life changes.
The bottom line is that any time you're considering obtaining a mortgage, whether that's to purchase a home, refinance a home, build a new home, or access equity using a home equity loan or home equity line of credit, taking time to know your options is invaluable.
That’s why an ARM may make sense for some borrowers. But it won’t make sense for everyone.
An ARM isn’t automatically better than a fixed-rate mortgage, and a fixed-rate mortgage isn’t automatically better than an ARM. They are different tools designed for different situations.
Before making a decision, consider:
How long you expect to stay in the home
Whether you could handle a higher payment
How important payment predictability is to you
Whether your plans depend on selling or refinancing
How the loan fits into your broader financial goals
What the payment could be under different rate scenarios
Any time you’re considering a mortgage, whether you’re purchasing a home, refinancing, building a new home or accessing your home’s equity, taking the time to understand your options is invaluable.
A good Mortgage Loan Officer (like my mortgage friends here at Merc) will take time to show you all the options, explain the potential benefits and tradeoffs, and help you compare different scenarios. The best mortgage isn’t necessarily the one with the lowest initial rate. It’s the one that best fits your goals, timeline and comfort level.
Disclosure: These figures are for illustration only and do not represent current Mercantile Bank rates or a rate quote. The rates used are for educational purposes only and not intended to be an advertisement. The annual percentage rate (APR), which includes financing costs, is not included. They also do not include property taxes, homeowners insurance, mortgage insurance, closing costs or other expenses that may affect the total monthly payment. This is not a commitment to lend. Contact a Mercantile Bank Mortgage Loan Officer for full details and a free rate quote.