An adjustable-rate mortgage (ARM) is a type of mortgage in which the interest rate applied on the outstanding balance varies throughout the life of the loan. The initial interest rate is fixed for a period at the beginning of the loan, typically 3, 5, 7 or 10 years. After that initial period, the interest rate can adjust at a pre-arranged frequency. The rate adjustment is based on an index value, like the U.S. Prime Rate, plus a margin determined by the lender.
The main features of an ARM are:
- Initial fixed-rate period: The interest rate is fixed for a certain period at the beginning.
- Adjustment period: After the initial fixed-rate period, the interest rate is adjusted at regular intervals (monthly, quarterly, annually, etc.)
- Interest rate caps: There are typically limits, or caps, on how much the interest rate can increase or decrease each adjustment period and over the life of the loan.
The benefits of an adjustable-rate mortgage include:
- Lower Initial Rates: ARMs typically start with a lower interest rate than fixed-rate mortgages. This could be beneficial if you plan to sell or refinance your home before the initial fixed-rate period ends.
- Potential Rate Drops: If interest rates fall, your payments could go down. However, this is a gamble as rates could also rise.
- Affordability: Because of the lower initial interest rate, borrowers may be able to afford a more expensive home than they could with a fixed-rate mortgage.
- Benefit from improving credit: If your credit score increases, when it’s time for the rate to adjust, you might qualify for a better rate.
However, ARMs also come with their share of risks, primarily the uncertainty of changes in interest rates. If rates rise significantly, your mortgage payment could increase substantially. Also, if your home’s value decreases, you might have difficulty selling or refinancing before the rate increases. As with any major financial decision, it’s essential to consider your personal financial situation, long-term plans, and risk tolerance when considering an ARM.