Understanding Adjustable Rate Mortgages

Last Updated 1/21/2015

Adjustable rate mortgages have remained one of the most attractive alternative options available those buying a home. So how do they work? What are their real pros and cons, and are one of these purchase mortgage loans for you?

Adjustable rate mortgages (ARMs) are often advertised with lower interest rates than conventional 30 year fixed rate purchase mortgages. This frequently makes them an enticing loan option. But what are the real perks and pitfalls of these loans? When should you use them when buying a home? When might borrowers be better off with a fixed rate mortgage?

Adjustable Rate Mortgages 101:

ARM loans are differentiated by the fact that their interest rates, and monthly payments can change over time. Traditionally these loans offer a limited fixed rate period, followed by regular adjustments tied to various rate indexes.

ARMs can have the initial rate fixed for 1, 2, 3, 5, and even 7 years. Each may then adjust at different regular intervals. This could be monthly, annually, or every two years. For example; a ‘5/1 ARM’ would have the initial rate fixed for the first 5 years, and would then adjust annually after this.

Some of the indexes these loans track along with include Prime and LIBOR. Note that it is important for those buying a home to understand the maximum amount their rate can go up on the first adjustment, as well as the lifetime cap. If you’ll be keeping this loan long term get an idea of where rates are likely to be at different stages.

The Cons of Adjustable Rate Mortgages

There are pros and cons of all loan programs. Some of the potential pitfalls of ARMs include:

  • Escalating interest rates and monthly payments
  • Difficulty in accurate budgeting
  • Uncertainty over when your purchase mortgage will be paid off
  • Uncertainty over where refinance mortgage rates will be later

So why choose an ARM?

The Pros of Adjustable Rate Mortgages

  • Lower monthly housing payments
  • Paying less interest on your home loan
  • Not paying a premium for long term fixed rate mortgages if you don’t need them
  • Flexibility in cash flow
  • Buying more home for your money

An ARM may be a particularly good choice if you anticipate your income to rise during the fixed period, you plan to sell and move home or trade investment properties before the fixed period is up, or you found your dream home, but need a lower payment to be able to afford it now.