The pros and cons of adjustable-rate mortgages

• How does an adjustable-rate mortgage work?
• Pros and cons
• Should I get an adjustable-rate mortgage?
• FAQs

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• An ARM secures your rate for the first few years of your loan, after which it changes periodically.
• The main benefit of an ARM is that you can often snag a lower rate than you would with a fixed-rate mortgage.
• But ARMs can be risky because your monthly payment could increase if your rate goes up.

When you buy a home, you'll choose between two basic types of mortgages: a fixed-rate mortgage and an adjustable-rate mortgage, or ARM

A fixed-rate mortgage locks in your rate for the entire life of your loan. For example, if you have a 30-year fixed-rate mortgage, you'll pay the same rate for all 30 years.

An ARM keeps your rate the same for the first few years, then periodically changes over time — typically once or twice a year.

How does an adjustable-rate mortgage work?

Your rate stays the same during the initial rate period

With an ARM, your rate stays the same for a certain number of years, called the "initial rate period," then changes periodically. For example, if you have a 5/1 ARM, your introductory rate period is five years, and then your rate will go up or down every year.

Some of the most common terms are 5/1, 7/1, and 10/1 ARMs, but many lenders offer shorter or longer intro periods. Some ARMs, such as 5/6 or 7/6 ARMs, adjust every six months rather than once per year.

Rates will depend on your mortgage lender, but in general, lenders reward a shorter initial rate period with a lower intro rate.

Your new rate will depend on an index and a margin

If your initial rate period is coming to an end, how do you know whether your ARM rate will increase or decrease?

ARM rates rely on two main factors: an index and margin.

An index is a tool used to measure rates. ARM rates are usually tied to an index such as the Secured Overnight Financing Rate (SOFR), the prime rate, the maturity yield of the one-year Treasury bill, or the 11th District cost of funds index.

If you check the respective index and see trends are going up or down, you'll have a good idea whether your rate will increase or decrease.

When a lender approves your loan, it assigns a margin for your rate. For instance, if you take out a 5/1 ARM with an index at 3% and a margin of 2%, your intro rate is 5%. Let's say when the intro period ends, the index has dropped to 1.5% — your rate for the following year will be 3.5% (1.5% index + 2% margin).

Adjustable-rate mortgage pros and cons

Pros

• It's often cheaper than a fixed-rate mortgage. ARM rates are typically lower than 30-year fixed rates, and some ARM rates may even be lower than rates on shorter fixed-rate terms, like a 15-year mortgage. This means that while you're in the fixed-rate period of your ARM, you could have a lower monthly payment, giving you more space in your budget for other necessities. 
• If rates decrease later, your monthly payment could go down. If rates start trending down in a few years, you could potentially have a lower rate than what you started with, which means your monthly payment would decrease as well.

Cons

• If mortgage rates increase, you're stuck with a higher rate. If rates are up when your ARM adjusts, you'll end up with a higher rate and a higher monthly payment, which could put a strain on your budget.
• You might not be able to get out of the ARM. A lot of ARM borrowers plan to sell their home or refinance before their rate adjusts, but unexpected circumstances can get in the way of that. For example, if something happens to your finances that prevents you from qualifying for a new mortgage, you won't be able to refinance.

ARMs can help you save money on interest and keep your monthly payments low, but they come with risks. If you're considering an ARM, be sure to consider both your initial monthly payment and how much that payment could increase overall. 

Should I get an adjustable-rate mortgage?

Whether an adjustable-rate mortgage is the right choice for you depends on how long you plan to stay in the home, rate trends, your monthly budget, and your level of risk tolerance.

If you plan to sell your home or refinance before the ARM's introductory period is over, you shouldn't have to worry about the rate adjusting. For example, if you plan on only living in the home for around five years, you might feel comfortable taking on a 7/6 ARM, since the rate won't adjust for seven years.

But be careful with this approach. Life doesn't always go as planned, and staying in the home for an extra few years could end up costing you if your rate goes up before you're able to sell. In this situation, you might want to consider giving yourself a bigger buffer, such as getting a 10/6 ARM.

Before getting an ARM, you should also get an idea of where rates might head in the coming years. Your mortgage loan officer can share their thoughts with you on this, but it's also a good idea to do your own research and understand what kind of trends you should be watching. Remember that no one has a crystal ball, and rates could always spike right before your ARM is set to adjust.

If you have a large income and are only spending a small portion of it on your mortgage payment, you might feel more comfortable getting an ARM since you have room in your budget for your payment to increase. Borrowers considering an ARM should always plan for the worst-case scenario.

Make sure you understand the terms of the ARM you're considering, including the maximum amount your rate and payment can increase. On the loan estimate you receive from your lender, it will show you how high your monthly payment could go if your rate hits the maximum. Consider if this number is compatible with your current budget.

The Consumer Financial Protection Bureau has a sample loan estimate for an ARM that you can familiarize yourself with so you know what to look for.

Adjustable-rate mortgage FAQs

An adjustable-rate mortgage is a type of home loan whose interest rate changes periodically according to the market after an introductory fixed-rate period. 

The riskiest aspect of adjustable-rate mortgages is that your rate could increase over time, causing your monthly mortgage payment to increase as well. 

An ARM might be a good idea for you if you think it's likely that rates will fall by the time the ARM adjusts. In 2023, rates are very high, so it's likely that they'll drop somewhat in the coming years. Now could be a good time to get an ARM, but it depends on how rates trend in the future, which can be hard to predict.

You'll generally need a credit score of at least 620 to get an adjustable-rate mortgage, but it depends on the type of ARM and your lender.

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