Adjustable-Rate Mortgages: The Pros and Cons

How does an adjustable-rate mortgage work?

When you take out an ARM, your loan will have a fixed interest rate for an introductory period, typically lasting from three to 10 years. That introductory, or teaser, rate will be lower than what you would get on a traditional 30-year, fixed-rate home loan. After that introductory phase, the rate on the mortgage will adjust periodically based on the terms of your individual loan and a benchmark interest rate index chosen by your lender. In most cases, the total length of the loan is 30 years.

In comparison, with a fixed-rate mortgage, the rate stays exactly the same during the life of the loan. Some people believe that fixed-rate mortgages are always the better choice. But ARMs can be an option for home buyers who know they will have the loan for only a few years, says Don Maxon, a certified financial planner in San Rafael, California.

“ARMs can make sense for customers who know they will be relocating in the near future or they know they will be paying off the loan in a few years, maybe due to retirement or expected inheritance or other receipt of funds,” Maxon says.

Types of adjustable-rate mortgage

It’s important to remember that changes to the interest rate will change your mortgage payment. There are many types of ARMs, but they all share the variable-rate characteristic. Some common types are:

Hybrid ARMs. These mortgages have two phases: a fixed-rate period — typically three, five, seven or 10 years — followed by an adjustable phase, during which your interest rate can move up or down, depending on an index of market rates chosen by your lender. How often the rate adjusts and other details about how your ARM works are written in the mortgage contract. Some possible hybrid ARMs:

• 3/1 ARM. The interest rate is fixed for three years and adjusts annually for 27 years.

• 5/1 ARM. The interest rate is fixed for five years and adjusts annually for 25 years.

• 7/1 ARM. The interest rate is fixed for seven years and adjusts annually for 23 years.

• 10/1 ARM. The interest rate is fixed for 10 years and adjusts annually for 20 years.

Interest-only ARM. An interest-only, or IO, ARM gives you a specified number of years, typically between three and 10, during which you pay only interest on your mortgage. Your payments stay low during the fixed-rate IO period. But paying only interest doesn’t reduce the loan amount. When the IO period ends your payments will be bigger, possibly much bigger, because they’ll include both principal and interest.

Payment-option ARM. These ARMs, which have become rare since the 2008 housing crisis, allow borrowers to choose one of several monthly payment options: an interest-only payment, a minimum payment that does not pay all the interest due or a fully amortizing payment that includes principal and interest.

Eventually, either after a specified period of time or if the loan balance grows too big because the borrower is making minimum payments that don’t cover all the interest due, the payment options end and the loan is recast, meaning that payments are adjusted to include principal and interest.

“Option payments generally lasted for five years if no loan-balance trigger was hit,” says Keith Gumbinger, vice president of HSH.com, a mortgage information company. “After that time, the payment was reset to fully amortizing (principal and interest payment).”

These loans are extremely complicated, and pose high risks to all but the wealthiest and most sophisticated borrowers. Many observers consider them to be one of the main factors behind the wave of home foreclosures that helped trigger the housing crisis and great recession. Borrowers should proceed very carefully if they’re ever offered one of these loans.

ARMs come with complicated terms and conditions. You’ll want to understand all of the terms used with your mortgage so you know how the loan works and how your payment may change. Here are some of the terms you’ll hear:

• Adjustment frequency: How often your interest rate will adjust after the introductory period.

• Benchmark index: The interest rate index to which payment changes on an ARM are tied.

• Introductory or teaser rate: The initial interest rate of your ARM, which does not change during the fixed-rate period of the loan.

• Interest-rate cap: The limit on how much your rate can rise with each adjustment.

• Payment cap: A limit on how much your mortgage payment can change.

The pros of an of adjustable-rate mortgage

• Low payments in the fixed-rate phase. A hybrid ARM offers potential savings in the initial, fixed-rate period. For example, with a 5/1 ARM, your introductory interest rate is locked in for five years before it can change. That gives you five years of predictable, low payments.

• Flexibility. An ARM can be a good idea if your life is likely to change in the next few years — for instance, if you plan to move or sell the house. You can enjoy the ARM’s fixed-rate period and sell before it ends and the less-predictable adjustable phase starts.

• Rate and payment caps. ARMs may have several types of caps, which limit the increases on your mortgage rate and the size of your payment. These include interest-rate caps (on how much the rate can change each time it adjusts and on the total rate change over the loan’s lifetime) and caps on how much the payment can grow each time the rate adjusts. You can ask a lender to explain the risks and show exactly how much the payments could be, at most.

• Your payments could get smaller. If prevailing interest rates fall, and drive down the index against which your ARM is benchmarked, there’s a possibility that your monthly payment could drop.

The cons of an adjustable-rate mortgage

• Your payments could get bigger. If interest rates are rising, your payments could increase after the adjustable period begins; some borrowers might have trouble making the larger payments.

• Things don’t go as planned. ARMs require borrowers to plan for when the interest rate starts changing and monthly payments may grow. Even with careful planning, though, you might be unable to sell or refinance when you want to. If you can’t make the payments after the fixed-rate phase of the loan, you could lose the home.

• Prepayment penalty. Some ARMs come with a prepayment penalty. This is a fee that can be charged if you sell or refinance the loan. If you plan on selling the home or refinancing within the first five years of the mortgage, you should ask the lender for a loan without this penalty.

• ARMs are complex. ARMs can have complicated rules, fees and structures. These are part of their appeal but can also pose risks for borrowers who don’t fully understand what they are getting into.