What may be a concern if you have an adjustable rate mortgage (arm)?

Why take an adjustable-rate mortgage (ARM)? Why not just take a fixed rate and not worry about what rates might do in the future?

That’s a fair question, and a good one. Adjustable rate mortgages can be a good choice for borrowers who anticipate financing a property for a relatively short period of time, say three to five years. ARMs can offer lower, “teaser” rates that are usually lower than fixed mortgage rates. And when caps are applied, an ARM may be the better overall choice.

What is an adjustable-rate mortgage (ARM)?

Adjustable-rate mortgages offer an introductory rate for a set number of years. After the introductory period ends, the home loan’s rate will adjust according to overall mortgage rates.

ARM loans typically offer introductory rates that are lower than the rates available for fixed-rate mortgages, which translates to lower monthly payments — during the initial period.

These initial “fixed” periods can range from 3, 5, 7 or even 10 years. The initial interest rate then adjusts, usually once per year. These loans (also called “hybrid ARM” mortgages) can make sense depending on your plans over the first 3 to 10 years of the loan term.

An ARM might be a good idea when…

You will be receiving a windfall

If you plan to receive a large amount of money in the next 5 years or so, an ARM might make sense. Say that you have a piece of real estate with a lot of equity that you plan to sell. Or, you will receive an inheritance. Maybe you will sell your business in 5 years.

In any of these circumstances, you could take a very low initial rate, then pay off the mortgage loan toward the end of the fixed period, before the rate changes.

You plan to sell the home early

If you plan to sell the home in the next 5 to 7 years, an ARM might be a good choice. Perhaps you are a first-time buyer looking for a smaller property, but plan to move into a bigger home as your family grows. Or your job will move you out of the area in the next few years.

In these cases, it might make sense to cash in on a lower interest rate for a few years. Just be careful that your plans are fairly certain. If they’re not, you may want a fixed-rate loan or an ARM with a very low rate along with low rate caps.

For more about how ARMs work, see our ARM primer or contact a trusted mortgage lender.

You want a tax deduction or will soon retire

You might have the cash to buy a home outright, but want a short-term loan for the mortgage interest tax deduction. Although this website does not give tax advice, it’s a fact that the mortgage interest deduction can have a big effect on the amount of taxes you pay. Check with your tax advisor.

If you make a lot of money now but will retire in 3 to 10 years, an ARM might make sense. You may be able to use the tax deduction to reduce your current adjusted gross income (AGI) thereby reducing your tax bill.

When you retire and your income decreases, you could pay off the loan amount if you no longer need the tax deduction.

Rate caps determine how much your ARM can change

An ARM has another important series of numbers that set limits on how much your loan rate can change. This series of numbers shows your rate caps.

For example, if you have an ARM with a 2/2/5 cap, your rate cannot change by more than:

• 2% after the fixed-rate period ends
• 2% for each adjustment period
• 5% over the life of the loan

So, with a 2/2/5 cap on a 5/1 ARM with an introductory interest rate of 3%, your loan’s rate:

• Would remain at 3% for the five-year introductory period
• Could reach as high as 5% after the intro rate expires
• Could increase by up to 2% at each subsequent yearly adjustment

Could never surpass 8% during the life of the loan

These lifetime caps on ARMs protect borrowers from out-of-control rate increases, but even a 5% rate increase would mean much higher monthly payments.

You’d want to refinance out of your ARM before its intro rate expires, especially during a high-rate environment.

So is an ARM for everyone?

For most home buyers, a fixed-rate mortgage will be the loan of choice since it still offers incredible interest rates and stability for the future.

With an ARM, rate adjustments can mean an eventual higher interest rate and higher monthly mortgage payment. If rates rise then you could end up with an expensive new rate (and higher loan payments) once the introductory rate period ends.

Still, there are many situations in which an ARM might make sense. Especially when interests are high, ARM rates are likely to be lower than fixed interest rates and might help aspiring buyers to become homeowners.

A mortgage professional can help you determine which type of mortgage is the best choice for you, based on your personal finances and current market conditions.

Potential homebuyers exit an open house in Redondo Beach, California.

As interest rates tick upward, it may be tempting for homebuyers to explore adjustable rate mortgages.

The appeal of an ARM, as it's called, can be the lower initial interest rate compared with a traditional 30-year fixed-rate mortgage. However, that rate can change down the road — and not necessarily in your favor.

"There is a lot of variability in the specific terms as to how much the rates can go up and how quickly," said certified financial planner David Mendels, director of planning at Creative Financial Concepts in New York. "No one can predict what rates will do, but one thing is clear — there is a whole lot more room on the upside than there is on the downside."

Interest rates remain low from a historical perspective but have been rising amid a housing market that already is posing affordability challenges for buyers. The median list price of a home in the U.S. is $405,000, up 14% from a year ago, according to Realtor.com.

The average fixed rate on a 30-year mortgage is 4.67%, up from below 3% in November and the highest it's been since late 2018, according to the Federal Reserve Bank of St. Louis. By comparison, the average introductory rate on one popular ARM is at 3.5%.

With these mortgages, the initial interest rate is fixed for a set amount of time. 

After that, the rate could go up or down, or remain unchanged. That uncertainty makes an ARM a riskier proposition than a fixed-rate mortgage. This holds true whether you use an ARM to purchase a home or to refinance a loan on a home you already own.

If you're exploring an ARM, there are a few things to know.

For starters, consider the name of the ARM. For a so-called 5/1 ARM, for instance, the introductory rate lasts five years (the "5") and after that the rate can change once a year (the "1″).

Don't just think in terms of a 1% or 2% increase. Could you cope with a maximum increase?

Some lenders also offer ARMs with the introductory rate lasting three years (a 3/1 ARM), seven years (a 7/1 ARM) and 10 years (a 10/1 ARM).

Aside from knowing when the interest rate could begin to change and how often, you need to know how much that adjustment could be and what the maximum rate charged could be.

"Don't just think in terms of a 1% or 2% increase," Mendels said. "Could you cope with a maximum increase?"

Mortgage lenders employ an index and add an agreed-upon percentage point (called the margin) to arrive at the total rate you pay. Commonly used benchmarks include the one-year Libor, which stands for the London Interbank Offered Rate, or the weekly yield on the one-year Treasury bill.

So if the index used by the lender is at 1% and your margin is 2.75%, you'll pay 3.75%. After five years with a 5/1 ARM, if the index is at, say, 2%, your total would be 4.75%. But if the index is at, say, 5% after five years? Whether your interest rate could jump that much depends on the terms of your contract.

An ARM generally comes with caps on the annual adjustment and over the life of the loan. However, they can vary among lenders, which makes it important to fully understand the terms of your loan.

• Initial adjustment cap. This cap says how much the interest rate can increase the first time it adjusts after the fixed-rate period expires. It's common for this cap to be 2% — meaning that at the first rate change, the new rate can't be more than 2 percentage points higher than the initial rate during the fixed-rate period.
• Subsequent adjustment cap. This clause shows how much the interest rate can increase in the adjustment periods that follow. This number is commonly 2%, meaning that the new rate can't be more than 2 percentage points higher than the previous rate.
• Lifetime adjustment cap. This term means how much the interest rate can increase in total over the life of the loan. This cap is often 5%, meaning that the rate can never be 5 percentage points higher than the initial rate. However, some lenders may have a higher cap.

An ARM may make sense for buyers who anticipate moving before the initial rate period expires. However, because life happens and it's impossible to predict future economic conditions, it's wise to consider the possibility that you won't be able to move or sell.

"I'd also be concerned if you do an ARM with a low down payment," said Stephen Rinaldi, president and founder of Rinaldi Group, a mortgage broker. "If the market corrects for whatever reason and home values drop, you could be underwater on the house and unable to get out of the ARM."

Rinaldi said ARMs tend to make the most sense for more expensive homes because the amount saved with the initial rate can be thousands of dollars a year.

"The difference between 3.5% and 5% can be $400 a month," Rinaldi said. "On a 7/1 ARM that could mean saving $5,000 a year or $35,000 altogether, so I can see the logic in that."

For a mortgage under about $200,000, the savings are less and may not be worth choosing an ARM over a fixed rate, he said.

"I don't think it's worth the risk to save $100 or so a month," Rinaldi said.