Here’s What Happens When You Have an Adjustable-Rate Mortgage

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An adjustable-rate mortgage leaves you subject to changing loan payments over time. Read on to learn more. 

Signing a fixed-rate mortgage loan is a great way to ensure that your monthly payments will be nice and predictable in the course of paying off your home. If you sign a 30-year fixed mortgage at 6%, for example, you know that’s the rate you’ll pay on your loan until your home is paid off, unless you refinance it. That could make it easier to work your monthly housing payments into your budget.

But you don’t have to lock yourself into a fixed-rate mortgage. There’s also the option to borrow via an adjustable-rate mortgage, or ARM. Doing so has its pros and cons, though, so it’s important to know what those entail.

How an ARM works

When you sign up for an ARM, your loan is subject to an initial interest rate that stays in place for a period of time. Your rate then has the potential to adjust at certain intervals, depending on the term of your loan.

A 5/1 ARM, for example, will have you paying the same mortgage rate for five years (that’s what the “5” stands for). From there, your loan’s interest rate can adjust once a year (which is what the “1” stands for).

The upside of a 5/1 ARM

You’ll often snag a lower interest rate initially on a 5/1 ARM than on a 30-year fixed mortgage. Case in point: Zillow says that the average rate on a 30-year fixed mortgage today is 6.48%. Meanwhile, the average 5-year ARM rate is 6.33%. So there’s the potential for a little bit of savings by going with an ARM.

The downside of a 5/1 ARM

Any time you sign an ARM, there’s a chance that your loan’s interest rate will climb over time, leaving you with more expensive monthly payments. Granted, that’s not guaranteed to happen, and it’s possible that your loan’s interest rate could go down over time, depending on market conditions.

The problem is, you don’t know what’s going to happen. So you’re taking a risk when you sign an ARM, because you could end up stuck with costly payments that are a struggle for you to afford.

Is an ARM right for you?

An ARM could be a good idea if you’re not planning to stay in your home for very long — such as, if you’re buying a starter home — and you expect to move before the interest rate on your mortgage has the potential to change. Otherwise, you’ll need to accept the fact that your loan might start costing you more over time.

It also really only makes sense to sign an ARM when the difference between that and a fixed-rate loan is substantial. If the difference in interest rates is minimal, the small amount of savings probably isn’t worth the risk.

Let’s say you sign a 30-year fixed $200,000 mortgage at 6.48%. That will leave you with a monthly principal and interest payment of $1,262.

Meanwhile, with a 5-year ARM at 6.33%, you’re looking at a monthly payment of $1,243 for your first five years. That’s a monthly savings of $19 and a yearly savings of $228. And over a five-year period, it’s a total savings of $1,140.

All told, that minimal amount of savings is probably not worth the risk of an ARM, because your payments could start rising after five years. On the other hand, if you were looking at savings of more like $100 a month with an ARM, that would more easily make the case for one.

All told, ARMs have their advantages, but they come with risk. Be sure that risk is worth taking on before making your choice.

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The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.Maurie Backman has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Zillow Group. The Motley Fool has a disclosure policy.

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