If you’re a homebuyer hunting for a low interest rate, you’ve probably come across adjustable-rate mortgages (ARMs). ARMs offer enticingly low introductory interest rates and promise more affordable monthly mortgage payments. So, what’s the catch?

While it may seem obvious, the adjustable portion of an adjustable-rate mortgage is a big part of what makes it different from a fixed-rate mortgage. After the initial interest period is over, your rate will adjust either up or down according to a fixed schedule. This is the mortgage adjustment frequency. ARM adjustment frequency could be the “make or break” factor that will determine if this is a good option for you.

We consulted with experts to help you understand more about ARMs and learn how their interest rates could work to your benefit. Depending on your situation, an ARM could be just the right option, but first you need to know how mortgage adjustment frequency works.

A calendar used to document mortgage adjustment frequency.
Source: (Hannah Busing / Unsplash)

What is the mortgage adjustment frequency on an ARM?

Sometimes called the change frequency or adjustment interval, mortgage adjustment frequency refers to how often your interest rate changes based on your adjustable-rate loan terms.

The 3/1, 5/1, and 7/1 ARM adjustment frequencies are common among lenders. But what do the numbers mean? The first number in this combo represents the length of the initial, fixed interest-rate period. The second number represents how often your rate adjusts after the fixed interest rate period ends. So, for a 7/1 ARM, the initial fixed interest rate period will last for seven years — that’s the “7.” After that period is over, your rate will adjust once every year — that’s the “1.”

Initial interest periods can last anywhere from six months to a decade. The mortgage adjustment frequency can vary from six months, a year, five years, or even longer in some cases. If you’re considering an ARM because you’re shopping for the lowest rate possible, the general rule is that loans with shorter initial interest periods tend to offer the lowest initial rates.

With an ARM, it’s common for your mortgage’s interest rate to go up after the initial rate period. This means that your monthly mortgage payment will increase in most cases. That said, while it’s less common, there’s technically also potential for your monthly mortgage rate to decrease if interest rates dip, particularly if your rate was set when the interest rates were higher.

The big takeaway for anyone planning to buy a home is that ARMs typically adjust once per year after the first rate window expires. However, the adjustment frequency range can vary. While one ARM borrower may keep a rate for five years, another may have rate changes every six months.

What are adjustable-rate mortgages?

Let’s backtrack a bit. You may have heard of an ARM, but you may not know much beyond the fact that these are mortgages with fluctuating rates. As we mentioned, ARMs have a fixed introductory rate and then change on a predetermined schedule. Lenders base rates on different indexes, including one-year Treasury funds, the Cost of Funds Index, or the London Interbank Offered Rate. Your lender will outline the details in your mortgage loan documents.

For many homeowners, ARMs are very attractive because the introductory rate is often much lower than the rate of a fixed-rate 30-year mortgage for the same loan amount.

“The adjustable tends to have the lowest interest rates,” shares Richard Helali, mortgage sales leader with HomeLight Home Loans. However, Helali doesn’t necessarily think everyone should jump into ARM mortgages just to snag that low introductory rate.

“Later on, rates can change, it’ll go up and down with the market,” Helali adds when explaining the potential dangers of hanging on to an ARM mortgage for too long. “Adjustable can become very expensive.”

However, homeowners with particular goals can benefit from ARMs. If you plan to sell or pay off the home before the initial fixed interest rate period expires, an ARM can be a great option.

Helali uses an example of a buyer purchasing a $2 million home, putting 25% down and planning to pay off the mortgage within the next few years. The buyer is given the option to lock in a five-year adjustable rate at 2.5%, a seven-year adjustable rate at 2.6% and a 10-year adjustable rate at 3%. By contrast, the interest rate for a fixed 30-year mortgage would be 3.125%. Since the buyer plans to pay off the mortgage before the initial fixed interest rate period ends, they save a lot of money on interest payments by picking a short-term ARM over a fixed-rate 30-year mortgage.

“It can be a great short-term solution,” Helali says of the ARM. In fact, he suggests that the option be placed on the table for anyone who is planning to sell within five to 10 years of purchasing a home. And while this initial rate can be attractive, it’s important to remember that during the second phase of an ARM, the rate adjusts to reflect current market rates.

“Once an adjustment period ends, which can be once every six months after the initial fixed period is over, the interest rate can increase by as much as 2%,” highlights Helali. However, he tempers the statement by adding that ARM rates also can decrease.

Here’s a look at a scenario Helali shares that details how homeowners with ARMs can see rapid increases:

  • A buyer starts with a five-year introductory interest rate of 2.5% on a $200,000 loan. The monthly payment is $790.
  • When the adjustment phase kicks in, the new market rates dictate that the rate rises to 4.5% for the next six months. Now their monthly payment is $1,013.
  • After six months, market rates have gone up again, and the next adjustment causes the rate to go up by an additional 2 percentage points. Now the buyer is paying 6.5% interest and a $1,264 monthly payment.

This example assumes that the index rate has gone up very quickly. It’s important to note, however, that there is a ceiling that limits just how high rates on an ARM can go. This is what’s known as the rate cap. While all ARM contracts specify rate caps, the caps can range widely. According to Helali, most interest caps on ARM home loans go as high as 11% or 12%. Lenders also tend to build in interest minimums that create a floor for just how low rates can go. In most cases, the cap is 1%, according to Helali.

Most lenders include three different types of caps in the loan offer:

Initial adjustment cap

This determines how much your rate can increase the first time it adjusts after your introductory fixed-rate period. Most lenders set this at 2 percentage points to 5 percentage points above your initial rate.

Subsequent adjustment cap

This cap determines how much your rate can increase in subsequent adjustment periods. Most lenders set this at 2 percentage points higher than the previous rate for each round. So if your subsequent adjustment cap is set at 2 percentage points, even if the index rate jumps by 3 percentage points, your rate can only increase by 2 percentage points.

Lifetime adjustment cap

The lifetime adjustment cap determines how much your rate can increase over the life of your mortgage. This cap is commonly set so your rate can never exceed 5 percentage points beyond your initial rate.

While introductory rate and mortgage adjustment frequency may make it seem like the strategy surrounding ARMs is to “get out” before rates catch up with you, Helali says that he sees clients stay satisfied with ARMs well past the initial interest period. Due to record-low interest rates in recent years, Helali is seeing clients that got locked into ARMs seven years ago decide to stay with them. He tells of an ARM client who recently declined a refinancing offer for a fixed loan after discovering that the fixed rate was higher than the latest ARM adjustment rate.

What are index and margin on an ARM loan?

The ARM index is the benchmark interest rate that reflects current market conditions. The index is used to help determine how much your rate sways higher or lower each time your loan adjusts. The ARM margin is the number of percentage points the lender tacks on. The index plus the margin determines how much interest you pay after the initial interest rate period ends.

A room in a house with a mortgage that will be adjusted.
Source: (Spacejoy / Unsplash)

What to consider when deciding on an ARM or fixed-rate mortgage

There are a few important factors to think about when you’re weighing the benefits of an ARM or a fixed-rate loan. While the low interest rates advertised for ARMs may catch your attention, you ultimately need to be realistic about both your current and near-future financial situation to make a responsible choice. Here’s a look at top considerations:

How much of a mortgage payment you can afford today

After being pre-approved, do your own analysis to see how much house you’re comfortable buying based on your debt-to-income ratio, future career plans, or personal goals. Your credit score plays a big part in qualifying for both ARMs and fixed-rate mortgages. It’s recommended by financial experts that your monthly mortgage payment not exceed more than 28% of your gross income. Because your monthly payment will likely be lower with an ARM, at least at first, you may find it easier to afford paying for an ARM than a fixed-rate mortgage.

Can you afford your payment if interest rates rise?

Run scenarios where interest rates reach their caps. You’ll want to make sure that even with the highest-rate scenario you can still make payments while also meeting all of your other financial obligations.

How long do you plan to live in your home?

If you’re buying a long-term home, an ARM won’t be the automatic best pick. If you plan to stay in your home for a maximum of five to seven years, an ARM has potential to allow you to pay less in interest before you ultimately sell, according to Helali.

Interest rate trends

Deciding if an ARM is a good choice isn’t something a homebuyer needs to do alone. Working with a loan officer can help you to get a sense of what interest rates might look like after your initial adjustment period expires. They’ll be able to tap into current and historical data to help you assess trends and how they might impact your loan payments.

A family cooking in a home with adjustable mortgage.
Source: (Jimmy Dean / Unsplash)

Is an ARM a good option for you?

Adjustable-rate mortgages can be a great option for a variety of homebuyers. Anyone planning to be a short-term owner has a reason to look into ARMs. However, someone buying their forever home can be a good candidate for an ARM, too. For example, if you’re expecting a big increase in income in the coming years, you can take advantage of the lower initial rate of an ARM to save money now knowing that you’ll be able to keep up with payments if rates increase.

Helali also has one last tidbit to share that could make an ARM an attractive option: Most ARMs don’t have prepayment penalties. That means you’re free to pay off your mortgage early. If you’re on track to be able to pay off your mortgage before the new interest rate kicks in, an ARM can help you to enjoy a few years with a much lower interest rate — and a lower monthly payment — than what you might pay with a fixed-rate loan.

The most important thing to keep in mind before jumping into an ARM is the mortgage adjustment frequency. As Helali says, it’s crucial to “check in” before every adjustment to make sure you aren’t going to get hit with a big jump in your monthly mortgage payment. And always have an exit strategy ready if rates turn sour: whether that’s to refinance the mortgage with better terms, sell the home, or pay it off in full.

Header Image Source: (Jan Huber / Unsplash)