Adjustable-Rate Mortgages: How They Work

Adjustable-rate mortgages (ARMs) are a type of home loan with an interest rate that changes periodically based on market conditions. Unlike fixed-rate mortgages, the rate on an ARM is initially lower but can fluctuate after a set period, which is known as the adjustment period.

The key feature of ARMs is their initial lower interest rate, which can make them more affordable in the early years of the loan. For example, a 5/1 ARM has a fixed rate for the first five years and then adjusts annually. This can be beneficial for borrowers who plan to move or refinance before the adjustment period begins.

However, the adjustable nature of these mortgages means that your payments can increase significantly after the initial fixed period. If interest rates rise, your monthly payments will increase, which can be a burden if you’re not prepared for higher costs.

ARMs often have caps to limit how much the interest rate can increase at each adjustment period and over the life of the loan. These caps help manage the risk of rapidly rising payments. However, even with these caps, your payments could still rise significantly.

In summary, ARMs can offer lower initial rates and monthly payments, but they come with the risk of fluctuating rates and potentially higher payments in the future. They are best suited for borrowers who anticipate moving or refinancing before the rate adjusts or who can comfortably manage potential payment increases.