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What Is an Adjustable-Rate Mortgage?

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Buying a home outright is something few people can do, so chances are, you'll need a mortgage to finance one. But should you get a fixed- or an adjustable-rate mortgage? If you're wondering what an adjustable-rate mortgage is, you'll learn everything you need to know here.

What is an adjustable-rate mortgage?

The interest rate you pay on your home loan can either be fixed or adjustable. With a fixed-rate mortgage, your interest rate stays the same throughout the life of your home loan. This means that if you lock in a 30-year fixed mortgage at 4%, you'll keep paying 4% until your home is paid off -- unless, of course, you refinance your mortgage and snag a new rate in the process.

With an adjustable-rate mortgage, or ARM, the interest rate on your home loan can change over time. That rate can go up, but it can also go down, depending on market conditions.

How does an adjustable-rate mortgage work?

When you sign up for an adjustable-rate mortgage, you're given an initial interest rate that's applicable for a preset period of time, which depends on the loan you sign up for.

With a 5/1 ARM, you'll have a fixed interest rate for the first five years of your home loan. From there, your interest rate will adjust once a year for the remainder of that loan. (Here, the five represents your fixed introductory rate period and the one represents the adjustment period.) Assuming you're looking at a 5/1 ARM with a 30-year term, you'd be subject to interest rate fluctuations once a year for the last 25 years of that loan.

With a 7/1 ARM, you'll enjoy a fixed interest rate for the first seven years, after which your rate will adjust once a year until your loan is paid off. And with a 10/1 ARM, you'll keep the same fixed interest rate for 10 years before it begins to adjust once a year. These are all common choices when it comes to adjustable-rate mortgages, but you may find other options, too, like a 3/1 ARM. And in some cases, you may have an ARM whose interest rate adjusts more than once annually once the introductory period is over, but those are rare.

All adjustable-rate mortgages use a financial index to determine whether their interest rates will go up or go down once the introductory period is over. One such index is the LIBOR (London Interbank Offered Rate) index, which tracks the rate that international banks charge one another for loans. Another index used for this purpose is the federal funds rate, or the rate at which U.S. banks and financial institutions lend each other money, usually on an overnight basis. As such, the interest rate on an adjustable-rate mortgage is not guaranteed to climb over time -- it can go down, depending on the index your mortgage lender uses.

Also with an adjustable-rate mortgage, you'll typically have an adjustment cap that dictates how much your interest rate can climb. Your initial adjustment cap will usually be somewhere between 2% and 5% -- meaning, your interest rate can't be more than 2% to 5% higher than it was during your introductory period. From there, your loan will be subject to subsequent yearly adjustment caps, and 2% is a common limit here. Finally, your ARM will also have a lifetime adjustment cap -- usually 5% -- which limits the extent to which your interest rate can go up during the life of your loan based on the initial rate you locked in.

Fixed-rate vs. adjustable-rate mortgages

A fixed-rate mortgage allows you to lock in the same interest rate for that home loan's entire term -- typically either 15 or 30 years. By contrast, an adjustable-rate mortgage will fluctuate once its initial introductory rate period expires.

Pros and cons of an adjustable-rate mortgage

Pros

  • You can lock in a lower initial interest rate than with a fixed-rate mortgage.
  • Interest rates can go down over time making monthly payments less expensive.
  • If rates fall, you won't have to refinance to get lower rates.

Cons

  • Rates can climb over time, making payments more expensive and unpredictable.
  • Some have a prepayment penalty. (You'll be charged to pay back your loan early.)

Different ARMs have different features, so when you compare mortgage rates, make sure you look for a loan that meets your needs -- especially if you might want to pay your mortgage off early. Keep in mind that the higher your credit score, the greater your chances of snagging an attractive offer.

Should I get an adjustable-rate mortgage?

There are certain circumstances where an adjustable-rate mortgage could really pay off. If you're not planning to stay in the home you're buying for very long, then an adjustable-rate mortgage makes sense. Say you're planning to live in your next home for five years or less. If you get a 5/1 ARM, you'll enjoy a lower interest rate during that time, but you'll also be getting out before your rate can climb.

Even if you're not planning to move quickly after buying your home, an adjustable-rate mortgage could still benefit you. If you lock in a low enough rate for the first number of years of your mortgage, you might then be able to pay more money toward your loan's principal. That, in turn, could save you money in interest over the course of your loan, even if your interest rate does adjust upward in time.

On the other hand, if you're the type who needs predictability when it comes to financial matters, then an adjustable-rate mortgage may not be for you. With an ARM, you run the risk of your monthly payments going up over time, and that's a risk you may not have the appetite for.

If you're applying for a mortgage when rates are low, then it could pay to lock in a fixed rate for 15 or 30 years rather than take your chances with an adjustable-rate mortgage.

The bottom line on adjustable-rate mortgages

Adjustable-rate mortgages offer home buyers a chance to pay less interest on a mortgage initially, and possibly less over time. Think about how long you're likely to stay in your home and whether you'll be able to afford a higher monthly payment once your ARM adjusts. While you might intend to sell your home before your adjustable-rate mortgage's introductory period expires, plans can change, so make sure you have enough wiggle room in your budget to allow for a higher mortgage payment should you find yourself on the hook for one.

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