Jan 19, 2023
If you have a fixed-rate mortgage, your payment is the same amount every month and never changes no matter how much the interest rates fluctuate. While there’s some comfort to that, wouldn’t it be amazing to have a lower house payment when you’re trying to tighten the purse strings?
That’s where an adjustable-rate mortgage, or ARM, comes in.
It’s a home loan with a lower interest rate than a fixed-rate mortgage. So, what’s the catch? The ARM starter interest rate doesn’t last forever, and your payments could go up or down depending on the going rate.
Here’s what you need to know about ARMs and if you should convert to one to get a lower house payment.
What exactly is an ARM?
An ARM is a home loan with an interest rate that can change periodically. There is usually a teaser rate in the loan’s initial period that’s lower than a fixed-rate mortgage. So initially, your monthly payments for an ARM are lower.
But once the teaser period ends, interest rates and your monthly payments can be higher—or lower—depending on the market index.
The most common ARMs are what’s known as 3/1, 5/1, 7/1, and 10/1. The first number represents how many years you’ll get a low introductory rate. The second number is how often the interest rate can change yearly.
However, the interest rates can go only so high because they are capped at a specific amount defined by the terms of your loan.
What an ARM payment looks like
Since the 5/1 ARM is the most popular, let’s use that as an example. If you start with a 5% rate on your ARM with a 2% cap, your total rate can go only as high as 7% after the initial fixed-rate period ends.
If that’s too much math to worry about, your lender can tell you the most you would have to pay with the different caps, so you’re never surprised.
And if you want some more math, here’s an example of the payments for an ARM vs. a 30-year fixed-rate mortgage on a $300,000 home.
- 5/1 ARM: Initial interest rate = 5.53%
Monthly payment: $1,709 for the first 5 years. Payment will then adjust based on the new interest rate and cap.
- 30-year fixed-rate mortgage: Interest rate: 7.26%
Monthly payment: $2,048 for 30 years.
ARMs sketchy past
You might remember that ARMs left a bad taste in everyone’s mouth due to the housing crash in the early 2000s that led to a foreclosure crisis.
Back then, a borrower’s income and asset verification were not verified by ARM lenders. So when the adjustment period kicked in, ushering in higher interest rates, some buyers couldn’t afford the spike in payments which led to mass foreclosures.
ARMs are vastly different now.
“Today’s ARMs are way more protected by underwriting guidelines and consumer protection laws,” says Mallory Miller, vice president of purchase lending for Lower.
The paperwork is now universal for each lender and easier for borrowers to understand. Plus, lenders are required to verify income and assets instead of taking the buyer’s word for it.
But there is still risk involved in ARMs. “You don’t know if the rate will go up or down when the adjustments period begins,” says Curtis Wood, founder and CEO of Bee, a mortgage app.
When it makes sense to switch to an ARM?
Converting a fixed-rate mortgage to an ARM can be a smart financial hack if you’ve crunched the numbers and determined that an ARM saves you money each month.
“With an ARM, there’s usually a lower rate and payment, generating newfound money in your monthly payment savings,” says Wood.
You could use the cash you save to pay down debt. Or, you could make regular extra payments to pay down your mortgage.
Additionally, it might be a good time to switch to an ARM if you don’t plan on staying in your home much longer and can sell it before the rate adjusts higher. For example, if you want to downsize soon, the 5/1 ARM could be ideal.
What are the costs to refinance to an ARM?
Before deciding if an ARM is a good move for you, consider the cost of refinancing.
“There are typical refinance fees, such as origination, appraisal fees, relevant title fees, and closing costs,” says Miller. The costs are rolled into the new loan, so you don’t pay any money out of your pocket at closing.
To make sure you’ll be in the black, compare an ARM’s monthly payment savings to the potential closing costs to identify the break-even period. And have a plan for rates going back up.
And contrary to popular belief, it’s not necessarily easier to refinance with the company already serving your fixed-rate mortgage. So shop around for the best rates and terms.
The bottom line
If you plan to stay in your house and simply want to take advantage of the initial teaser rate of an ARM, you can usually refinance back to a predictable fixed-rate mortgage. Just keep in mind you are subject to whatever the going market rate is at the time, which could be higher than the fixed rate you have now.
And refinancing isn’t necessarily a sure thing. It might not be possible if your finances take a nose dive or the value of your home goes down.
On the flip side, you don’t have to go back to a standard fixed-rate mortgage. You can generally refinance to a new ARM to snag the low introductory rate again.
Lower house payments for three, five, or more years sure sound tempting these days. But just make sure you can live comfortably and afford higher monthly payments if the interest rates rise once the adjustment period begins.