Is an Adjustable-Rate Mortgage a Smart Idea in 2024?

Adjustable-rate mortgages, also known as variable mortgages, can come with significantly lower initial interest rates compared to a fixed-rate mortgage loan. Because of this, choosing an ARM when buying a home can result in significantly lower monthly housing expenses.

While ARMs can be a good choice in some cases, and usually have some built-in consumer protections, they are still riskier for most home buyers than using a 15- or 30-year fixed-rate mortgage. Here's a quick overview of what buyers need to know about ARMs before deciding the best way to finance their next home purchase.

What is an adjustable-rate mortgage and how does it work?

As the name suggests, an adjustable-rate mortgage, or ARM, is a home loan whose interest rate can fluctuate over time.

Specifically, most ARMs have an interest rate that is fixed for the first few years (often referred to as a "teaser" rate -- especially when it's significantly lower than the prevailing fixed mortgage rate). The rate will then adjust periodically at specified intervals for the remainder of the 30-year term.

For example, a 5/1 ARM is the most common type. It has an interest rate that stays the same for the first five years, and resets according to the loan documents every year thereafter. It's common for the initial rate to stay the same for five, seven, or even 10 years, and then to adjust every six months or one year thereafter.

In most cases, there are limits that govern how much an ARM's interest rate can increase at any given time, as well as an overall upper limit beyond which the interest rate can never rise, regardless of market conditions. This is relatively new and is a product of the predatory mortgages that were common before the 2007-2008 financial crisis, and ARMs are generally more consumer-friendly than they were in previous generations.

Pros and cons to keep in mind

The most obvious advantage of an adjustable-rate mortgage is a lower initial interest rate. As of this writing, the average 30-year fixed mortgage rate in the United States is 6.87%, compared with 6.30% for a 5/1 ARM, according to the Mortgage Bankers Association. On a $400,000 home loan, this translates to $1,800 per year in savings. That's a pretty big difference.

There's also the possibility that your interest rate could decline in the future if rates go down, and without the closing costs associated with refinancing.

Conversely, the downside of an ARM is that your future mortgage payments can be rather unpredictable beyond the initial "teaser" period. The rate on an ARM is typically tied to a benchmark interest rate, and could potentially reset to a higher rate after the first few years.

Of course, many home buyers see the rates they can get with an adjustable-rate loan and think "I'll just refinance before the initial rate period is over."

However, while refinancing your loan is certainly an option, there's no guarantee that rates will be lower in five or seven years. It isn't terribly likely, but what if 30-year mortgage rates are 10% in the United States once your initial rate period is over? Your adjustable-rate loan would likely get significantly more expensive, and refinancing wouldn't be beneficial. This is a major risk factor of using adjustable-rate loans, so buyer beware.

Who should consider an adjustable-rate home loan?

The short answer is that an adjustable-rate mortgage is appropriate in a few situations. First, and most common, is if you're only planning to be in the home for a few years. If you're reasonably sure you'll end up selling the home before the loan's interest rate starts to adjust, an ARM can be a good way to keep your costs low.

There are other, more specific, situations where an ARM could make good financial sense. For example, if your credit score is relatively low right now but is improving, and you'll be in a better position to get a mortgage lender's best rate in five years, you still have refinancing risk -- but the odds could be more favorable that you'll be able to get a better rate.

Having said that, if you're shopping for a home to live in for years to come, a fixed-rate mortgage is typically the best option. After all, if rates drop, you can refinance whenever you want.