Adjustable-rate mortgage pros and cons

Quick insights

Preparing to buy a home for the first time? If so, you may have heard the term “adjustable-rate mortgage” (or “variable-rate mortgage”) and wondered what all the fuss was about. With interest rates fluctuating and affordability means different things to homebuyers, ARMs may spark interest.

But what is an adjustable-rate mortgage? What are the benefits, and what is a danger of taking out a variable-rate loan? We’ll answer those questions and more in this guide to adjustable-rate mortgage pros and cons.

What is an adjustable-rate mortgage?

An adjustable-rate mortgage is a type of home loan in which the interest rate changes periodically. This is unlike a fixed-rate mortgage, which maintains a constant rate for the loan’s entire term.

With an ARM, you benefit from a lower introductory rate for a set period. Once that period ends, the rate adjusts based on a financial index, like the Secured Overnight Financing Rate (SOFR).

For example, with a 5/1 ARM, you’d have a fixed interest rate for the first five years. Then, the loan adjusts annually after that. This adjustment could lead to higher or lower monthly payments depending on the direction of interest rates.

ARM loans feature an initial fixed-rate period, typically for three, five, seven or 10 years. After that, the interest rate adjusts periodically, as outlined in your loan agreement. This might be every six months, as is the case with a 5/6 ARM or 10/6 ARM, or every year, like with a 5/1 or 7/1 ARM.

Let’s say you get a 7/1 ARM. Your rate will be fixed for the first seven years, offering stable, predictable payments. Once that period ends, the rate adjusts annually. However, these adjustments are capped, limiting how much the rate can increase or decrease both annually as well as over the life of the loan.

As mentioned, ARM loans include a variety of terms, such as 5/1, 7/1 and 10/1, with the first number indicating the fixed-rate period in years and the second showing how often the rate adjusts afterward.

What are the advantages of an ARM loan?

With the basic definition of an ARM loan in mind, let’s now look at the pros and cons of ARM loans so you can make the best possible decision for your financial situation and goals:

Lower monthly payments with low introductory rates

One of the most obvious—and perhaps most attractive—benefits of an ARM loan is the potential for a lower introductory rate. However, it’s important to note that a lower introductory rate isn’t always guaranteed with an ARM.

It’s important to pay close attention to the terms and compare your ARM loan rate to that of a comparable fixed-rate mortgage.

While ARM loans don’t always have lower interest rates than fixed-rate mortgages, they are more likely to, and that’s a big draw for price-conscious homebuyers.

Rates have the potential to decrease further

Another benefit of an ARM is the possibility of lower payments if interest rates decrease after the introductory period.

Unlike a fixed-rate mortgage, where you’d need to refinance to take advantage of falling rates, ARMs adjust automatically. This means your monthly payments could go down without any additional action on your part.

Can be helpful for real estate investors

If you’re purchasing a property as an investment, an ARM can make good financial sense. The lower initial rate can potentially increase your return on investment (ROI). This is particularly beneficial for properties you plan to sell within the initial fixed-rate period.

Option to refinance

Even if you opt for an ARM now and future rates become unfavorable, refinancing into a fixed-rate loan is an option. This flexibility makes ARMs a viable choice for borrowers who want to start with lower payments but still want a strategy to switch plans if needed.

What are the downsides of an ARM?

Any discussion of the potential benefits and drawbacks of ARM loans should also address the following disadvantages.

Rates could increase over time

One of the biggest dangers of taking on a variable-rate loan, like an ARM, is that your interest rate can increase after the initial fixed period ends. ARM loans typically start with a lower fixed rate for a set number of years (commonly three, five, seven or 10), but after that, the rate adjusts periodically based on market conditions. If interest rates rise, so could your monthly payments.

This unpredictability can be a challenge for borrowers who prefer stability or are working with a tight budget. Without a plan to manage potential rate hikes, your affordable mortgage today could become financially stressful tomorrow.

You’ll need a plan for affording higher payments long-term

ARMs require a certain level of financial preparedness. If your monthly payments increase substantially after the adjustment period, you’ll need to make sure you can comfortably cover the higher amount. This is why ARMs are often better for those expecting steady income growth or planning to refinance before the adjustment period kicks in.

Can be complicated to prepay

If you’re hoping to pay off your loan early, an ARM isn’t always the most straightforward option. Some lenders include prepayment penalties in the loan terms, a charge for paying off your mortgage ahead of schedule. Make sure you discuss prepayment terms with your lender before committing to an ARM.

Sometimes difficult to qualify for

Adjustable-rate loans can have different qualification criteria compared to fixed-rate mortgages. Approval criteria vary by lender, but they will consider factors like credit score and debt-to-income (DTI) ratio before approving borrowers. A down payment of 20% on a conventional mortgage is typically required to avoid private mortgage insurance (PMI).

Alternatives to ARM loans

If you’re not entirely comfortable with the risks that come with an ARM, there are alternatives to consider.

Fixed-rate mortgages are the most obvious option, as they lock in a consistent interest rate for the life of the loan. This means your monthly payments will remain stable, regardless of market fluctuations.

For qualified borrowers, government-backed loans, such as Federal Housing Administration (FHA) or U.S. Department of Veteran Affairs (VA) loans, can also provide competitive rates and terms.

Ultimately, what works best depends on your financial goals and how comfortable you are with potential rate changes.

Is an ARM loan a good idea?

The answer depends largely on your circumstances and long-term plans. There are scenarios where the benefits of ARM loans could outweigh the risks.

In general, an ARM loan may be a good alternative to a fixed-rate mortgage if you are:

Planning to live in the home for a short period of time

If you’re buying a home with plans to relocate or sell within a few years, an ARM can be a smart move. The lower initial rate could save you a significant amount of money before the adjustment period begins.

A real estate investor

For investors, ARMs can provide a cost-effective solution for properties that will be sold or refinanced in the short term. Lower initial payments free up cash for other investments, maximizing overall returns.

Going to refinance later on

If you’re confident interest rates will decrease over the next few years, or you’re committed to refinancing before the rate adjusts, an ARM may suit your needs. Refinancing to a fixed-rate mortgage later on can help you lock in more stability once you’ve secured a better rate.

Just starting your career and expect income growth

For those who are early in their careers, an ARM can offer budget-friendly monthly payments when you’re just starting out. If you expect your income to grow over time, the potential payment increases may become more manageable as your financial situation improves. However, this can be risky to do; for example, if you’re fired or laid off unexpectedly during this time, you could be left scrambling.

Comfortable with some level of risk

Not everyone is comfortable with the unpredictability ARMs can bring. However, if you’re financially flexible and have a high tolerance for risk, this loan type can be an effective tool to save money in the short term.

Taking out a jumbo loan

With jumbo loans—which exceed conforming loan limits (CLLs) set by the Federal Housing Finance Agency (FHFA)—ARMs are an increasingly popular choice.

Able to make extra payments during the introductory period

If you’re disciplined with your finances, you could use the initial lower payments of an ARM to your advantage. By making additional payments during the fixed-rate period, you’ll reduce your principal faster and save on interest over the long term.

In summary

When it comes to the pros and cons of ARMs, the decision will ultimately boil down to your desire for flexibility over predictability. ARM loans can be a powerful tool for homebuyers who understand the risks and have a clear strategy in mind. However, for those who prefer peace of mind and a steadier financial outlook, fixed-rate mortgages may offer a greater level of comfort.

Your home is likely one of the biggest investments you’ll make in your lifetime. Choosing a mortgage to suit your situation is a step toward building financial stability and achieving your dreams of becoming a homeowner.

Whatever path you decide to take, take the time to consider your lifestyle, budget and long-term goals. A little preparation now can make a world of difference later.