An adjustable rate mortgage (ARM) is a loan with an interest rate that will change throughout the life of the loan. An ARM may start out with lower monthly payments than a fixed-rate mortgage, but you should know that your monthly payments may go up over time and you will need to be financially prepared for the adjustments.
All ARMs have adjustment periods that determine when and how often the interest rate can change. There is an initial period during which the interest rate doesn't change – this period can range from as little as six months to as long as 10 years. After the initial period, most ARMs adjust.
How do ARMs work? Let's take a look.
A 3/1 ARM has a fixed interest rate for the first three years. After three years, the rate can adjust once every year for the remaining life of the loan. The same principle applies for a 5/1 and 7/1 ARM. If the rates increase, your monthly payments will increase; however, if rates go down, your payments may not decrease, depending upon your initial interest rate.
Most ARMs also typically feature an adjustment "cap" which limits how much the interest rate can go up or down at each adjustment period. For instance:
A 7/1 ARM with a 5/2/5 cap structure means that for the first seven years the rate is unchanged, but on the eighth year your rate can increase by a maximum of 5 percentage points (the first "5") above the initial interest rate. Every year thereafter, your rate can adjust a maximum of 2 percentage points (the second number, "2"), but your interest rate can never increase more than 5 percentage points (the last number, "5") over the life of the loan.
When considering an ARM, ask yourself:
If the mortgage rate increases, can I afford a higher mortgage payment? Use our calculator to estimate how a higher mortgage rate can impact your mortgage payment.
Do I plan to live in my home for less than five years – or less than the adjustment period? If yes, this mortgage may be right for you – but remember that if you have difficulty selling your home as planned, you are responsible for the higher mortgage payments.
To determine the best type and structure ARM for your situation, lean on your lender or financial professional for guidance. Be sure you know the details of how and when this type of loan may change your monthly payments. You may also want to consider other types of mortgages. See how adjustable rate mortgages compare to fixed-rate mortgages.
Follow this series to learn more about how things work in the mortgage industry and visit My Home by Freddie MacSM where we discuss it all. Click here to read the previous post in our How it Works blog series.