Adjustable-rate mortgages (ARMs) can save borrowers money in interest over the short to medium term. But if you are holding one when it's time for its interest rate to reset, you could face a much higher monthly mortgage bill. Here is what to expect and what you can do about it.
Key Takeaways
- With an adjustable-rate mortgage, the interest rate is usually fixed for a period of time, after which it can change.
- When rates go up, ARM borrowers can expect to face higher monthly mortgage payments.
- Borrowers have some protection against unmanageable increases in the form of rate caps.
How Adjustable Rate Mortgages (ARMs) Work
With an adjustable-rate mortgage (ARM) the lender locks in your interest rate for a certain period of time. Typically that initial interest rate will be lower than the ones that are available on fixed-rate mortgages. Sometimes lenders offer especially low teaser rates if they're eager for new business.
However, when that initial rate period ends, the mortgage rate will reset and can go considerably higher. The rate can continue to reset periodically over the remaining term of the loan.
The initial period on ARMs often ranges from one to 10 years but can also be shorter or longer.
The ARMs most lenders offer today are called hybrid ARMs because they act like a fixed rate mortgage during the introductory period, after which they turn adjustable. Hybrid ARMs are expressed in terms of two numbers: the length of the fixed period and the frequency with which the interest rate can adjust after that. For example, a 5/1 ARM is fixed for five years, after which it can adjust every year thereafter. A 10/6 ARM is fixed for 10 years and can adjust every six months after that.
Note
Adjustable-rate mortgages are also commonly called variable rate mortgages.
How Much Rates Can Rise
Lenders can't just raise an ARM borrower's interest rate however they see fit. For one thing, ARMs are tied to an index, such as the interest rate on Treasury bills. If Treasury bills are paying a higher rate of interest at the time an ARM adjusts, the rate on the ARM can go up commensurately.
On top of the indexed interest rate, the lender adds a margin of several percentage points, which is how the lender makes its profit. A typical margin might be 2% or 3%.
ARMs are also subject to caps on how much rates can rise with each adjustment period and in total over the life of the loan, known as a lifetime cap. ARM contracts should specify a rate cap structure. For example, a 5/1 ARM might come with a 2-2-5 rate cap structure. That means that it could go up as much as 2% the first time it adjusts and as much as 2% in any one-year adjustment period after that, but it can never go up more than 5% in total.
So, if that ARM started out at 6%, its rate could conceivably rise as high as 8% with the first adjustment, assuming Treasury rates are up at least that much. It could then rise as much as 2% in any subsequent adjustment period, but it could never go higher than 11%.
Important
The rates on ARMs can go either up or down when they adjust. Your lender should give you a loan estimate with a "Projected Payments" section showing both the maximum and minimum monthly payments that would be possible in any given time period.
How to Avoid Payment Shock
While rate caps provide some protection against dramatic rate increases, some borrowers could find their payments becoming unmanageable once adjustments begin.
This will not be a problem if you take out, say, a 5/1 ARM knowing that you won't be staying in the home for five years and will have paid off the mortgage before it has an opportunity to adjust. However if your plans change and you're still in the home in year six, you could face a big bump in your monthly mortgage payments.
For that reason it's worth doing the math to see whether your budget is likely to stretch far enough to accommodate a worst-case scenario of maximum rate increases.
If you do plan to stay in the home for an indefinite period, also consider the possibility of refinancing the ARM before it adjusts using a new fixed-rate mortgage. That will guarantee that your rates won't rise beyond whatever the fixed-rate loan charges.
Some ARM lenders offer a provision called a conversion option that allows you to trade your ARM in for a fixed-rate mortgage with that same lender after a certain period of time. They may charge a fee for this.
If you still have an ARM when the rate is about to adjust you shouldn't be totally blindsided. According to the Consumer Financial Protection Bureau (CFPB), your mortgage servicer should let you know "your new payment amount seven to eight months in advance, so you can budget for it or shop for a new loan."
Can the Lender Change the Index for an ARM?
That's possible but unlikely. As the CFPB notes, "Generally, the index your lender uses won't change after you get your loan, but your loan contract may allow the lender to switch to a different index in some situations."
What Is an Interest-Only ARM?
An interest-only ARM is one in which you pay only interest and no principal for a certain fixed period. After that, you must pay both interest and principal, which can mean substantially higher monthly payments even if interest rates haven't gone up.
What Are Points on an ARM?
Points are a form of prepaid interest, with each point costing you 1% of the loan amount. Lenders may offer you a lower initial interest rate in return for points, but that benefit will usually end when the rate adjusts for the first time.
The Bottom Line
An adjustable-rate mortgage doesn't have to be risky, as long as you understand what can happen when your interest rate resets. Knowing ahead of time how much more you might owe each month can prevent sticker shock and help ensure that you are able to keep up with your payments.
