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Six Essential Facts about ARMs for Homebuyers

Happy couple standing outside of the new home they purchased with an adjustable rate mortgage.
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Editor’s note: Quorum is not affiliated with any of the companies mentioned in this article and derives no benefit from these businesses for placement in this article.

When you’re in the market for a new home, you have a lot of decisions to make, such as what neighborhoods in which to house-hunt. Some of the most important questions in the home-buying process relate to your finances: How much do you have for a down payment? How much can you afford in a monthly mortgage payment? Does a fixed-rate or adjustable-rate mortgage (ARM) make more sense for you? To answer that last one, here are the most important things to know about ARMs.

Fixed-Rate Mortgages vs ARMs

If you finance your home through a fixed-rate mortgage, your interest rate stays the same throughout the life of your home loan. For example, if you get a 30-year mortgage with a 6.25% rate, it won’t change no matter what happens to market interest rates.

An ARM only has a fixed interest rate during its initial period, which can be anywhere from three to 10 years. But after that, your interest rate adjusts at the intervals determined by your loan contract. This means your interest rate and, therefore, your monthly payment could increase or decrease depending on the going interest rates at every adjustment period.

An ARM’s Index and Margin

When shopping for a mortgage and looking at ARMs, you need to pay attention to the terms index and margin. Mortgage providers tie their ARMs to an index, which is a benchmark interest rate that takes general market conditions into account. An ARM’s margin is the number that a lender determines will be added to the index to determine its interest rate when the initial fixed-rate period ends.   

During the variable-rate period of an ARM, your interest rate follows the up or down movement of its corresponding index, plus the amount of your margin. Some of the most popular indexes for ARMs include the following:

  • Prime rate, a financial institution’s base rate for its most creditworthy customers
  • London Interbank Offered Rate (LIBOR) index
  • S. Treasury indexes based on things like T-bill rates

Different Types of Adjustable-Rate Mortgages

ARMs are designated by two numbers. The first number is the length of the initial fixed-rate period. The second number says how often your rate adjusts after that. Here are the most common types:

  • 3/1 ARM: Three years fixed that adjusts annually thereafter
  • 3/3 ARM: Three years fixed that then adjusts every three years
  • 5/1 ARM: Five years fixed before adjusting annually
  • 5/5 ARM: Five years fixed and then the rate adjusts every five years
  • 7/1 ARM: Seven years fixed before adjusting annually
  • 10/1 ARM: 10 years fixed before adjusting annually

ARM types, such as a 5/6, 7/6 or 10/6, adjust every six months. Some financial institutions offer a 5/25 ARM. It has an initial five-year fixed-rate period before the interest rate adjusts and then stays fixed for the remainder of the loan.

ARM Caps

An ARM’s caps determine how much your interest rate can go up or down as follows:

  • Initial cap: the limit on how much it can change the first time
  • Periodic cap: the limit on how much it can change at every remaining adjustment period
  • Lifetime cap: the maximum limit it can change over the life of the loan

For example, say you take out a 5/1 ARM with 5/2/5 caps. After your initial five-year fixed period, your rate could go up or down no more than 5% at its first adjustment, no more than 2% during every annual adjustment thereafter, and not more than 5% total over the full term of the loan.

Pros and Cons of ARMs

The initial fixed rate on an ARM is typically lower than that of a fixed-rate mortgage because the lender doesn’t have to guarantee that rate for the life of the loan. This means you can buy a home with a lower monthly payment, leaving more room in your budget for your needs, wants and goals during that initial period.

However, you won’t know exactly what your interest rate will be once you enter the adjustable-rate period. You could end up in a situation where your new monthly payment exceeds your budget, especially if it was already tight due to inflation, a recession or some other factor beyond your control. 

If you don’t plan to be in your home longer than your ARM’s initial period, you can avoid that uncertainty while still enjoying the lower initial rate. Of course, that assumes that your plans don’t change or hit a snag, such as the inability to find a buyer for your home.

Additional Mortgage Resources

If you’re seriously considering an ARM, make sure to specifically ask about the following:

  • The ARM’s index and margin
  • The rate and duration of its initial fixed period
  • Its adjustment terms and caps

You can find more information about ARMs and the home buying process from the following resources: the CFPB’s Consumer Handbook on Adjustable-Rate Mortgages, the NCUA’s guide to Homeownership and Renting and The Home Buying Guide from Quorum.

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CUNA 2021 diamond award trophy icon

CUNA 2021 Diamond Award Winner

Content Marketing

Quorum derives no benefit from businesses in return for placement in this blog.

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