What Is an Adjustable-Rate Mortgage (ARM), and Is One Right for You?

Over the past 15 years, interest rates have been historically low. Given the low rates, most homeowners have been opting for fixed-rate mortgages, on which the rate won’t change for the life of the loan. The rapid rise in mortgage rates over the past year, however, has led to a resurgence in demand for a type of home loan that had been largely out of favor during the previous decade.

Adjustable-rate mortgages, or ARMs as they’re commonly called, have tripled in popularity during the past two years and now account for roughly 9 percent of all new mortgage loans. The spike in popularity comes as rising rates on conventional fixed-rate mortgages have made it difficult for some borrowers to afford a new home.

An ARM will typically offer a lower rate than what’s available with a fixed-rate mortgage. However, after a certain period of time, the rate on an ARM will adjust (hence the name). Many borrowers find the lower so-called teaser rate available with an ARM an appealing option to help minimize payment size in the early days of home ownership. But are they right for you? Before deciding which type of home loan may be the best fit for your situation, there are some things to consider.

What is an adjustable-rate mortgage?

An adjustable-rate mortgage is a type of home loan that charges a set interest rate for a period of time at the beginning of the life of the loan. However, unlike a fixed-rate mortgage that charges a set rate for the entire life of the loan, the rate on an ARM may rise or fall based on a formula established at the beginning of the loan. The period of time when the interest rate will remain unchanged typically can vary between one, three, five, seven and 10 years. After the initial fixed period is over, rates will adjust based on an agreed-upon fixed interval. Intervals between adjustments are typically six months or one year.

Typically, two numbers are used to indicate the terms of the loan, with the first referring to the initial period during which the interest rate is fixed and the second number representing the interval between rate adjustments. For example, a 3/6 ARM means that the introductory interest rate is set for the first three years of the life of the loan, and the interest rate will be adjusted every six months beginning at the end of the fixed period.

How is the rate adjustment determined?

ARM rates are calculated using an underlying index rate and then adding an agreed-upon markup to that index. The index, or base rate, can fluctuate, but the markup amount is set. Common indexes used to set the base rate are the yield of one-year constant maturity Treasury bills or the Secure Overnight Financing rate, which is a broad measure of the cost banks pay overnight while using U.S. Treasury bonds as collateral.

Let’s say you took out an ARM with a teaser rate of 5 percent. And under terms of the loan it would adjust at the end of the teaser period based on the sum of the agreed-upon underlying index plus 2 percent. If, after the teaser period was over, the base index had a yield of 4 percent, your mortgage rate would increase to 6 percent (4 percent base plus 2 percent adjustment).  

Additionally, some ARM mortgages set caps that limit how much the interest rate charged can change in any given year as well as for the total lifespan of the loan. For example, a commonly used formula for ARMs limits interest fluctuations to no more than 2 percent in any given year and not more than 5 percent during the life of the loan. That means that adjustments to the interest rate you would pay can’t increase or decrease by more than 2 percent per year, and your interest rate for the life of the loan would never be greater or less than 5 percent higher or lower than the teaser rate that applied at the beginning of the loan.

What are the risks?

While adjustable-rate mortgages can be appealing, particularly when interest rates on fixed mortgages are elevated, they aren’t without drawbacks. Two in particular are worth considering.

• You might end up buying more house than you need or can afford. The lower teaser rate available with an ARM can make the monthly payment on a more expensive house manageable during the initial phase of the loan. As a result, once the teaser rate period is over and the monthly payments adjust to reflect higher interest rates, some buyers may find that they have bought more house than they can afford.
• Adjustable-rate mortgages can be more complex than a fixed-rate loan. Borrowers who don’t fully understand the complex details of an ARM could be at risk from conditions they may not have fully considered.

What are the benefits?

• ARMS offer lower rates and can make a home more affordable during the initial fixed-rate period of the loan. The lower payment can be particularly useful for would-be buyers who expect to retire other financial obligations, such as student loan debt or car loans, during the initial teaser period of the mortgage.
• The structure of an ARM loan provides borrowers greater flexibility than a conventional fixed-rate mortgage. This can be appealing for someone who is confident they will be in their new home for just a few years because it allows them to borrow at the more attractive teaser rate knowing that they are likely to move and payoff the mortgage before the rates may be adjusted higher.
• Your payment could actually go down when it is adjusted. While no one knows for certain where rates will be in one year much less 10 years from now, it is possible that rates could go down while you are holding an adjustable rate mortgage, and the terms of your ARM will allow you to reap the benefits of the decline without having to go through the process of refinancing as you would if you held a conventional fixed-rate mortgage.

Is an ARM right for you?

Under the right circumstances, an adjustable-rate mortgage can be an attractive option for interest-rate sensitive buyers or those who could benefit from the flexibility offered by these types of loans. But there are risks associated with ARMs, and they aren’t the right solution for every borrower.

Whether you decide a conventional fixed-rate mortgage, or an ARM is right for you, a Northwestern Mutual financial advisor can help you look at how a mortgage fits with your entire financial picture.

Please see your real-estate professional for specific recommendations to meet your personal needs and objectives as it relates to mortgage rates and options. Financial representatives do not issue, or make recommendations, for mortgage options.