What You Need To Know About Adjustable-Rate Mortgages

Adjustable-rate mortgages (ARMs) are a unique type of lending product that home buyers can take advantage of. They function as a middle ground between the traditional fixed and variable rate loan options. As such, ARM loans offer a great blending that gives buyers a low, locked-in rate in the introductory period alongside a later period of variable fluidity. This provides a buyer thinking that their needs are better suited to the use of a variable rate hedge in the short term.

Instead of taking out a loan with variable interest rates that can fluctuate alongside the prevailing market rates or a fixed rate that locks you into an arrangement that may end up costing you more as market rates plummet, an ARM gives you great stability in the short term (during a period of higher than average interest rates, typically) while keeping the ability to fluctuate alive for the long term.

CNBC notes that adjustable-rate mortgages are often crafted with a seven or 10-year initial fixed period with a variable adjustment that comes every six months or every year after this first phase ends (a 10/6 ARM or 7/1 ARM).

These loans provide a unique benefit to homeowners seeking security upfront and the potential for rate reduction over the long horizon. However, they remain a risky proposition because rates could reduce or shoot higher for a lengthy period, leaving your payments skyrocketing and you in a financial lurch (via The New York Times).

An adjustable-rate mortgage's first and most important feature is that the interest estimate associated with your agreement and ongoing repayments will change. The interest rate on your loan will remain fixed for the introductory period, of course. Still, after this time expires, your loan is subject to market pressures that remain outside your control for the remainder of its lifetime.

This can be a positive force in your fiscal life, but there's really no way to be certain whether the overarching interest rate structure of the open market will continue to work in your favor. One definitive thing is that you can't count on always seeing rates move in a positive direction for your finances — there will inevitably be periods that go against your best interests. Since April 2022, for instance, market rates have risen by more than 1.5% (as of June 30, 2022), according to Bankrate.

Understanding that market rates are fickle and can change slightly or even dramatically over the course of just a few months can help you gauge the risk and reward tradeoff that an adjustable-rate mortgage can provide.

As a result of the variable rate and agreed-upon timeline for adjustment, you should expect your payments to fluctuate alongside the interest rate that dictates your overall mortgage picture. Because of the potential for change over time, homeowners taking advantage of an ARM may be saddled with larger monthly payments for one or more readjustment terms.

As you continue to pay back the loan, you'll be responsible for stable payments each month during the initial fixed mortgage period. Still, your contribution can change substantially alongside the interest rate governing the remaining balance. If your rate increases, you should expect to see the monthly payment that you are responsible for go up as well. CNBC notes that homeowners using ARMs should be prepared for this when going into the arrangement.

While an adjustable-rate mortgage may provide significant benefits over the extended lifetime of the loan, preparing for the leaner times through the repayment is crucial to making the most of the lending option. When payments are lower, setting aside a bit of extra capital for the inevitably higher repayment requirements that will come can set you up for success.

One of the main benefits of an ARM loan is that the initial fixed-rate period enjoys a fixed rate that is lower than the market value for traditional, fixed-rate mortgage loans (via Rocket Mortgage). In order to entice borrowers to utilize this type of funding, interest rates on the initial fixed period are offered at rock bottom pricing, allowing you to enjoy significant savings on your tacked-on interest and the monthly payments that come in the first years of the mortgage.

This is great for those with other commitments to factor in during the beginning stages of new homeownership — or a move to a new property. If you are moving into a new home and have a newborn to support, for instance, the lower monthly payments in the first five to 10 years of the agreement can act as a godsend for managing other essential fiscal needs. Likewise, for homeowners moving to a new property while putting a child through college, the four years of higher education can line up perfectly with cut-rate repayments each month on the mortgage loan.

While an ARM can offer great initial benefits, over the long term, budgeting for the repayments each month can be immensely difficult. This is because it's impossible to plan for how the market may change between the present moment and the next reexamination of the interest rate associated with your loan (via Investopedia).

As a result, homeowners who use an adjustable-rate mortgage loan to fund their real estate purchase and then stick with the loan terms (instead of refinancing your mortgage later down the road) may find it difficult to budget over the long term for important expenses or big-ticket items. Planning a blow-out vacation, for instance, may not be possible without a very long lead time because of the potential for mortgage repayments to increase by hundreds of dollars during the next readjustment period.

However, an ARM can be the perfect entryway into homeownership and minimal repayments for an introductory period before tackling the mortgage loan obligation differently. As you approach the first readjustment period, investigating the market rates and considering refinancing can give you access to renewed terms that provide the same great benefits you are already experiencing. If the market is moving upward over the course of the year leading up to your fixed-rate expiration, locking in a new fixed-rate loan can protect you against continuing momentum that will translate into continued increases in your monthly payments.

Another great approach to the use of an ARM loan is for those with plans to stay in their home for just a few years before searching the market for a new property again.

For example, suppose you already know that your home purchase is a short-term solution for some lifestyle arrangement that exists in the present but won't persist over more than a few years (up to about a decade). In that case, using an ARM can effectively act as an entryway into enjoying a lower-than-market average fixed-rate loan (via CNBC). If you sell before the fixed-rate term ends, you can effectively use the mortgage option to reduce an already favorable rate even further.

For a market in an upward value arc, buying a home with the smallest possible repayment obligation can give you access to the home's rising equity value without the expensive price tag that may come along with a higher interest rate. Then, when you're ready to move, you can sell the property at a premium and take advantage of a highly positive swing in momentum for your family's net worth.