An adjustable-rate mortgage (ARM) is often discussed as an option to help lower initial costs and increase flexibility, particularly in a high-cost housing market. However, it’s important to understand how these loans work, their potential risks, and strategies for managing adjustments over time.
ARMs 101
An ARM is a loan with an interest rate that will change throughout the life of the mortgage. In contrast, a fixed-rate mortgage has a fixed interest rate that is set when you take out the loan and does not change. In contrast to the stability of fixed-rate mortgages, with an ARM, your monthly payments may go up or down over time.
ARMs have two distinct periods:
The initial period: This period lasts between three to 10 years after you receive your loan, during which time the interest rate on your loan doesn’t change. It’s also known as the fixed-rate period. The most common ARM terms have initial periods of three, five or 10 years.
The adjustment period: Once the initial period ends, your loan will adjust. All ARMs have adjustment periods that determine when and how often the interest rate on your loan can change. Your adjusted rate will be based on your individual loan terms and the current market.
The name of your ARM will indicate the duration of the initial period and how often in a year your rate can adjust. For example, the most common adjustable-rate mortgage is a 5/6 ARM. This means you will have a fixed-rate period of five years. After that, you can expect your ARM to adjust once every six months.
ARMs also typically offer a rate cap structure, consisting of these three different caps, which limit how much your rate can increase or decrease:
Initial cap: Limits how much your rate can increase when your rate first adjusts.
Periodic cap: Limits how much your rate can increase from one adjustment period to the next.
Lifetime cap: Limits how much your rate can increase or decrease over the life of your loan.
Let’s say you have a 5/6 ARM with a 2/1/5 cap structure. This means that after your initial period expires, your rate can increase by a maximum of 2 percentage points above the initial interest rate. Every adjustment period thereafter, your rate can adjust a maximum of 1 percentage points. Over the life of the loan, it can never increase more than 5 percentage points above the initial rate.
When to Consider an ARM
ARMs typically provide lower mortgage rates during the initial period, which can translate into significant savings. This could be a good choice if you plan on moving or selling within five years — or before the adjustment period of the loan — or if interest rates are high when you buy. You could also select an ARM if you plan to refinance before the initial period ends. Just be sure to account for refinancing costs, which are similar to the costs you pay when closing on your home purchase. Additionally, some ARMs require you to pay penalties upward of several thousand dollars for refinancing early.
How to Prepare for Adjustment
Because your interest rate could adjust higher, ARMs come with a level of uncertainty about future monthly payments. This is important because you are still responsible for making your monthly payments if your rate adjusts upward. Freddie Mac’s Adjustable-Rate Mortgage Calculator can help you determine how much your monthly payments may cost over the life of the loan. With this knowledge handy, you can budget ahead of time for even the highest rate adjustments allowable according to your loan’s terms.
To determine the right mortgage for your situation, lean on your lender or financial professional for guidance and check out the resources and tools available at https://myhome.freddiemac.com.
When it comes to mortgages, you have options, making it important to carefully consider the features and benefits of each type of loan.
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