Adjustable-rate mortgages have benefits and drawbacks that you should carefully consider when choosing a home loan. Learn about how ARMs work, the different types of ARMs, when an ARM may be a good option, and when to think about refinancing to a fixed-rate mortgage. Show
 How Do ARMs Work?An adjustable-rate mortgage (ARM) is a loan with an interest rate that will change throughout the life of the mortgage. This means that, over time, your monthly payments may go up or down. This is different from a fixed-rate mortgage (FRM), which has a fixed interest rate that is set when you take out the loan and does not change. With this type of loan, your monthly payments will not change. ARMs have two distinct periods:
After the initial period, most ARMs adjust. Simply put, when your loan adjusts, your interest rate may change.
You need to make sure you are financially prepared for rate adjustments if you are considering an ARM. What Are the Different Types of ARMs?There are different types of ARMs that lenders offer. The name of these ARMs will indicate:
Let’s look at an example: The most common adjustable-rate mortgage is a 5/1 ARM. This means you will have an initial period of five years (the “5”), during which the interest rate doesn’t change. After that time, you can expect your ARM to adjust once a year (the “1”). Most ARMS will also typically offer a rate cap structure, which is meant to limit how much your rate can increase or decrease. There are three different caps:
Let’s say you have a 5/1 ARM with a 5/2/5 cap structure. This means on the sixth year — after your initial period expires — 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 shopping for an ARM, you should look for interest rate caps you can afford. When Should You Consider an ARM?Many homeowners choose an ARM to take advantage of the lower mortgage rates during the initial period. You may consider an adjustable-rate mortgage if:
If rates are low, it would make more sense to get a fixed-rate mortgage to lock in the low rate. Keep in mind that, with an ARM, there is a level of uncertainty about how much your monthly payment will go up or down. Depending on the market, your rate could adjust upward and increase your monthly payments. It is important to be mindful of this because you are still responsible for making your monthly payments if your rate adjusts upward.
If you’re looking to buy a home, you might be overwhelmed with the sheer number of mortgage choices. Mortgage lenders offer a variety of options when it comes to the type of financing you can get to buy or refinance a home. In addition to varying loan types and terms, you’ll have to decide whether you want a fixed-rate loan or an adjustable rate mortgage loan (ARM). In this article, we’ll be discussing the 5/1 ARM, which is an adjustable rate mortgage with a rate that’s initially fixed at a rate lower than comparable fixed-rate mortgages for the first 5 years of your loan term. What Is A 5/1 ARM Loan?
A 5/1 ARM is a type of adjustable rate mortgage loan (ARM) with a fixed interest rate for the first 5 years. Afterward, the 5/1 ARM switches to an adjustable interest rate for the remainder of its term. The words “variable” and “adjustable” are often used interchangeably. When people refer to variable-rate mortgages, they likely mean a mortgage with an adjustable rate. A true variable-rate mortgage has an interest rate that changes every month, but these aren’t common. An ARM has a fixed rate for the first several years of the loan term that’s often called the teaser rate because it’s lower than any comparable rate you can get for a fixed-rate mortgage. Rates may be fixed for 7 or 10 years, although the 5-year ARM is a very common option. Once the fixed-rate portion of the term is over, the ARM adjusts up or down based on current market rates, subject to caps governing how much the rate can go up in any particular adjustment. Typically, the adjustment happens once per year. When the rate adjusts, the new rate is calculated by adding an index number to a margin specified in your mortgage documentation. Common indexes used to figure out rates for ARMs include the Secured Overnight Financing Rate (SOFR), the Cost of Funds Index (COFI) and the Constant Maturity Treasuries (CMT). Each time your interest rate changes, your payment is recalculated so that your loan is paid off by the end of your term. Terms on ARMs are usually 30 years, but they don’t have to be. What Should I Look For When Shopping For A 5/1 ARM?
When you’re comparing loan options, there are some special numbers to pay attention to when looking specifically at ARMs. For example, you may see one advertised as a 5/1 ARM with 2/2/5 caps. Let’s break down what that means, one number at a time.
Other than the margin in your loan documentation, there’s no limiting factor to how much your interest rate could adjust down in any particular year if interest rates have moved lower. How 5/1 ARMs Work: An Example
To really get a feel for an ARM, let’s do an example comparing it with a fixed-rate mortgage for a $250,000 loan amount. In our hypothetical example, let’s say you can get a 30-year fixed-rate mortgage at 4%. We’ll compare that against a 5/1 ARM with 2/2/5 caps and an initial interest rate of 3.5%. On the fixed-rate mortgage, you’re looking at a monthly payment of $1,193.54, not including taxes and insurance. Our ARM has an initial payment of $1,122.61. You save $70.93 per month for the first 5 years of the loan, but it’s important to remember this adjusts in the sixth year. If your ARM interest rate goes up by the maximum amount allowed under the cap, your new payment would be $1,377.05. In the seventh year, if interest rates were higher and it went up by the maximum amount, the new payment at a 7.5% interest rate would be $1,648.71. Finally, if rates went way up, the lifetime cap on interest rate increases is 5%, so your new payment in the eighth year would be $1,788.81. It’s important to take these potential adjustments into account when you’re budgeting. When getting yourself into an ARM, it’s helpful to understand the relationship between principal and interest and how it changes over time as you get into your mortgage term. At the beginning of your term, almost all of your mortgage payment will go toward paying interest. As the years go by, this flips so that by the end of the term, the vast majority of the payment is toward the principal. But you can also put extra money toward the principal every month if you aren’t subject to any prepayment penalties your lender might charge. Rocket Mortgage® doesn’t have these. We’ll get into the benefits of paying down principal in a second; adopting this strategy could be helpful for those who plan ahead. 5/1 ARM Loan: Pros
Adjustable-rate mortgages have their benefits, but they’re not right for everyone. Although there is a fixed-rate portion of the loan that may make it more attractive than a truly variable-rate mortgage, it’s important to realize that the potential for future upward adjustment means that there is less certainty than you would get with a fixed-rate mortgage. In understanding the differences between adjustable-rate and fixed-rate mortgages, it helps to take a look at the pros and cons of ARMs. Let’s start with the benefits of ARMs. Lower Initial Interest RateBecause the interest rate can change in the future, an ARM is structured so that you can get a lower interest rate for the first several years of the loan than you would if you were to go with a comparable fixed rate. This lower payment can give you financial flexibility to buy things you need for the house, invest or put it back directly toward the principal. Potential To Pay Less Overall InterestOne way to save money over the life of the loan when you get an ARM is to put the money you save from that lower interest rate back directly toward the principal. In this way, even if the interest rate adjusts upward, you’re paying less in interest because you’re paying it on a lower balance. To see how this works in practice, let’s take a look at the earlier scenario where we were saving $70.93 per month by going with an ARM. If we put that monthly savings on the principal, that’s $4,255.80 less on the balance at the end of the first 5 years. That means that instead of your payment being $1,377.05 when the interest rate resets at 5.5%, it would be $1,350.91, not to mention the interest savings over the lifetime of the loan. Could Be Good For Short-TimersIf you know that you’re in a starter home and will be moving in a few years, you might move before the interest rate ever adjusts. This requires some planning and forecasting of your future, but if it works out, you may not have to deal with the rate going up. 5/1 ARM Loan: Cons
As we’ve mentioned above, ARMs do have their downsides. Let’s run through them. Potential For A Higher Mortgage Payment Long-TermThe teaser rate on ARMs is lower than the prevailing market rate on fixed-rate mortgages because investors know the interest rate can adjust over time if rates increase. As such there is the potential for your long-term payment to be higher, potentially increasing to the lifetime cap depending on market conditions. To combat this, you can refinance into a fixed-rate loan if you qualify. You’ll Likely Pay More Interest Over TimeBecause the interest rate will often go up, you’re going to have a higher chance of paying more interest over time. It’s true that you can refinance your adjustable-rate mortgage into a fixed-rate mortgage when it comes time for your rate adjustment. However, you should be aware that there are closing costs associated with any refinance either in the form of upfront fees or paid off over time by taking a higher interest rate. Closing costs can be anywhere between 2% – 6% of the loan amount, although they tend to be lower on a refinance. Rate Difference Isn’t Always Worth ItAs interest rates go down, there tends to be a narrowing of the yield curve. This gets a little bit technical, but basically the yield curve deals with the difference between fixed- and adjustable-rate mortgages. If you’re saving a significant amount on the front end of the loan by going with an ARM, it can be worth it. If the difference is 10 basis points (10 hundredths of a percentage point), not so much. Is A 5/1 ARM Loan Right For You?
Assuming market conditions with a decent spread between fixed and adjustable rates, it can make sense to get an adjustable-rate mortgage, particularly if you know you plan to be out of the house by the time the rate would adjust. This is because the upfront interest rates can be lower than anything you would get for a fixed rate under normal circumstances. If market conditions change and there’s more of a difference between adjustable rates and fixed-rate mortgages, the lower rate on an ARM can help provide you financial flexibility. In addition, as we saw earlier, you can pay down quite a bit of principal by taking the payment savings in the initial years and putting it back toward the balance. If you plan on being in your house for a long time, it’s probably best to take a look at a fixed-rate mortgage. This will provide you with long-term payment certainty. 5/1 Arm FAQs
Here are the answers to some commonly asked questions. Why are 5/1 ARMs referred to as hybrids?They’re referred to as hybrids because they behave like fixed-rate mortgages during the introductory period. For 5 years, home buyers who choose an ARM enjoy fixed payments, generally at a lower interest rate than buyers with a fixed-rate mortgage. It’s only after the introductory period ends that ARMs may become more expensive and unpredictable, depending on what is happening with interest rates in the macroeconomic environment. What is a convertible ARM?Homeowners with a convertible ARM have the option of converting their ARM into a fixed-rate mortgage at a time designated in the mortgage contract. Homeowners enjoy low introductory rates as well as the peace of mind that comes with having a fixed-rate option. Please note that Rocket Mortgage doesn’t offer convertible ARMs. What is a 5/1 ARM interest-only loan?An interest-only loan is a type of non-conforming mortgage that charges only interest for a set introductory period. For example, if you choose a 5/1 interest-only ARM, you’ll only make interest payments for the first 5 years. Thereafter, your mortgage would start amortizing, which means you would begin paying principal and interest as part of your monthly mortgage payment. We don’t offer these types of loans. What do I do if interest rates increase dramatically?Your best bet might be to refinance your mortgage. Many homeowners choose an ARM to take advantage of the lower monthly mortgage payment during the introductory period, and plan to refinance or move before that period ends. What is the difference between a 5/1 and a 7/1 ARM?It’s simply a matter of understanding the shorthand. The first number is the number of years in the introductory period. The second refers to how often the mortgage can reset the interest rate. So, a 7/1 ARM has a 7-year introductory period and the interest rate can be adjusted every year. A 7/6 ARM has a 7-year introductory rate and the rate can adjust every 6 months. The Bottom Line: 5/1 ARMs Can Save You Money Under The Right Circumstances
If you don’t plan to live in a home longer than the introductory period of an ARM, you might save money. If your plans change, you might need to refinance to avoid the interest rate adjustments that can wreak havoc on your monthly budget. Want to learn more about buying a house? Our Learning Center has the resources you need. If you’re ready to get started, you can apply online or give us a call at (833) 326-6018. What best determines whether a borrowers interest rate on an adjustable rate loan goes up or down?As we alluded to, the factor that best determines whether a borrower's investment on an adjustable-rate loan goes up or down is the current market. The market's condition drastically impacts the rate of investment.
What determines the interest rate that a borrower must pay on an adjustableThe lender decides which index your loan will use when you apply for the loan, and this choice generally won't change after closing. The margin is the number of percentage points added to the index by the mortgage lender to set your interest rate on an adjustable-rate mortgage (ARM) after the initial rate period ends.
What determines the interest rate that a borrower must pay on an adjustableWhat determines the interest rate that a borrower must pay on an adjustable rate mortgage? the margin added to the index determine the note rate that is the rate the borrower will pay on the loan.
What is adjustableAdjustable-Rate Mortgages. a mortgage with an interest rate that may change one or more times during the life of the loan. ARMs are often initially made at a lower interest rate than fixed-rate loans depending on the structure of the loan, interest rates can potentially increase to exceed standard fixed-rates.
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Which items listed below determine if the payment will go up or down on an adjustable rate mortgage?
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