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What Is an Adjustable-Rate Mortgage?

Key Takeaways

  • An adjustable-rate mortgage (ARM) has a fixed rate during the early years; afterwards, the rate can change periodically.
  • ARMs could save you money during the early years if the initial rate is lower than that of a fixed- rate mortgage.
  • Before choosing an ARM, make sure you have the budget flexibility to make larger monthly payments during periods when the rate may increase.

Buying a home is a big financial commitment. That means the mortgage you choose can have a big impact on how much interest you pay over time.

One option, a fixed-rate mortgage, is simple to understand: it offers the same interest rate throughout the term of the loan. Meanwhile, an adjustable-rate mortgage (ARM) is a little more complex.

Here’s what you need to know about ARMs.

How ARMs work

As the name implies, ARMs have interest rates that adjust over time. Typically, the starting rate remains fixed for a set number of years, such as three, five, or even as much as 10 years. After that fixed period ends, the rate changes periodically, typically on an annual basis.

It’s important to realize that the first scheduled adjustment — after the initial fixed-rate period ends — could increase your monthly mortgage payments. You’ll want to plan for this date so you’re prepared to afford a potentially more expensive payment when the rate adjusts.

An ARM can be beneficial if the initial interest rate is lower than that of a fixed-rate mortgage. This means you’d pay less money during the early years of the loan.

When ARMs make the most sense

ARMs can be a popular mortgage choice when interest rates are high. And if you only plan to stay in your home for a few years, they can be an option worth considering as long as you sell your home before the rate changes.

If you have a higher tolerance for rate variability in general, an ARM could also be a good choice for you.

Important considerations

Before deciding on an ARM for your mortgage, make sure you understand these key points:

  1. The fixed period is the length of time you keep the initial interest rate, while the adjustment frequency is how often the rate changes afterwards. For instance, a 5/1 ARM will have a fixed rate for the first five years, and then will adjust once a year after the fixed period ends. Note: To get maximum benefit from an ARM’s lower initial rate, look for a fixed period of five years or more.
  2. The index is what the lender bases its rate adjustments on, often either the prime rate or LIBOR (London Interbank Offer Rate). The margin is how much the lender will add to the index when adjusting your rate. The total of the two is typically rounded to the nearest 0.125%. For instance, if the one-year LIBOR rate is 1.8% and the margin is 2.25%, the new rate would be 4.00%.
  3. The ARM terms will include how low the rate can go (the floor), how high your rate can increase the first year after the fixed period ends (the initial cap), how much it can increase with each successive adjustment (the subsequent cap), and how much your rate can increase during the life of the loan (the lifetime cap). For instance, an ARM with caps of 2/2/5 means:
    • 2 = The rate will not increase or decrease by more than 2% for the first adjustment after the fixed period ends.
    • 2 = The rate will not increase or decrease by more than 2% for any subsequent rate adjustments.
    • 5 = The rate will never increase by more than 5% above the initial starting rate.

The bottom line

Before you choose an adjustable-rate mortgage, take a hard look at your current budget and consider your potential for future income increases. Make sure you could comfortably afford your monthly mortgage payments if your interest rate was ever to reach the lifetime cap; otherwise, there could be major financial implications.

Also, consider how long you plan to live in the home. Is it a starter home or a forever home? Those buying a starter home might find an ARM more appealing since they won’t be in the house long enough to feel the effects of the adjustable-rate change.

More information

Picking the right home mortgage is as important as choosing the right home. Our dedicated colleagues can help you find the right financing option for your unique situation. To learn more, visit us online or reach out to a Citizens Bank Loan Officer.

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