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With an adjustable-rate mortgage, your rate could go up or down later.
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An ARM secures your rate for the first few years of your loan, then changes the rate periodically.
Common ARM types include 5/1 or 10/1 ARMs, or ARMs that adjust every six months such as 7/6 ARMs.
Your ARM rate depends on a rate index, and on the margin determined by your lender.
When you buy a home, you’ll choose between two basic types of mortgages: a fixed-rate mortgage and an adjustable-rate mortgage, or ARM.
A fixed-rate mortgage locks in your rate for the entire life of your loan. For example, if you have a 30-year fixed mortgage, you’ll pay the same rate for all 30 years.
An ARM keeps your rate the same for the first few years, then periodically changes over time — typically once or twice a year.
How does an adjustable-rate mortgage work?
Your rate stays the same during the initial rate period
With an ARM, your rate stays the same for a certain number of years, called the “initial rate period,” then changes periodically. For example, if you have a 5/1 ARM, your introductory rate period is five years, and then your rate will go up or down every year.
Some of the most common terms are 5/1, 7/1, and 10/1 ARMs, but many lenders offer shorter or longer intro periods. Some ARMs, such as 5/6 or 7/6 ARMs, adjust every six months rather than once per year.
Rates will depend on which lender you go with, but in general, lenders reward a shorter initial rate period with a lower intro rate.
Your new rate will depend on an index and a margin
If your initial rate period is coming to an end, how do you know whether your ARM rate will increase or decrease?
ARM rates rely on two main factors: an index and margin.
An index is a tool used to measure rates. ARM rates are usually tied to an index such as the Secured Overnight Financing Rate (SOFR), the prime rate, the maturity yield of the one-year Treasury bill, or the 11th District cost of funds index.
If you check the respective index and see trends are going up or down, you’ll have a good idea whether your rate will increase or decrease.
When a lender approves your loan, it assigns a margin for your rate. For instance, if you take out a 5/1 ARM with an index at 3% and a margin of 2%, your intro rate is 5%. Let’s say when the intro period ends, the index has dropped to 1.5% — your rate for the following year will be 3.5% (1.5% index + 2% margin).
Adjustable-rate mortgage pros and cons
Pros
Good option if you plan to move or refinance soon. Some ARM rates are starting lower than fixed rates right now, but they may go up later. If you plan to move before the initial rate period ends, you could benefit from a lower ARM rate. You may also be able to refinance into a fixed-rate before your rate adjusts.If rates decrease later, you could get a lower rate. If rates start trending down in a few years, you could potentially have a lower rate than what you started with, which means your monthly payment would decrease as well.
Cons
If mortgage rates increase, you’re stuck with a higher rate. If rates are up when your ARM adjusts, you’ll end up with a higher rate and a higher monthly payment, which could put a strain on your budget.You might not be able to get out of the ARM. A lot of ARM borrowers plan to sell their home or refinance before their rate adjusts, but unexpected circumstances can get in the way of that. For example, if something happens to your finances that prevents you from qualifying for a new mortgage, you won’t be able to refinance.
ARMs can help you save money on interest and keep your monthly payments low, but they come with risks. If you’re considering an ARM, be sure to consider both your initial monthly payment and how much that payment could increase overall.