An adjustable-rate mortgage, or ARM, is one of the more popular types of loans for buying a house or refinancing your mortgage. After an initial period of several years, during which your payments remain the same, your interest rate and monthly principal and interest adjust annually depending on market forces. The biggest drawback? ARM payments can increase after the fixed-rate period ends, resulting in more money out of your pocket.
Typically, ARMs have a lower initial interest rate compared with fixed-rate mortgages. An interest rate cap also limits the maximum amount your principal and interest payment may increase over the life of the loan.
Here’s an example to help illustrate the difference between an ARM and a fixed-rate mortgage. If you get a 30-year fixed mortgage on a $200,000 loan at 4% interest, you’ll pay $955 a month and $107,804 in interest over the life of the loan.
If you buy that same home with a seven-year ARM at an initial 3% interest rate, your monthly payment drops to $843. So if you sell the home in five years, you could save close to $7,000. But if you stay in the home for more than seven years, you run the risk of interest rate spikes. This is one reason an ARM may be a good idea if you know you’ll be selling your home after a short time.
The initial interest rate cap does provide some protection against large interest rate swings. There are two types of caps: annual and life-of-the-loan. The annual cap restricts the amount your interest rate can change in any given year. The life-of-the-loan cap limits the maximum and minimum interest rate for the life of the mortgage.
The Federal Housing Authority (FHA) offers a standard one-year ARM and four “hybrid” versions. Hybrid ARMs offer an initial interest rate that is constant for the first three, five, seven, or 10 years. Afterward, the interest rate will adjust annually. Some examples of FHA ARMs include:
- 1- and 3-year ARMs. These may increase by 1 percentage point each year after the initial fixed-interest-rate period, and 5 percentage points over the life of the mortgage.
- 5-year ARMs. These allow for increases of 1 percentage point annually and 5 percentage points over the life of the loan or increases of 2 percentage points annually and 6 points over the life of the loan.
- 7- and 10-year ARMs. These may increase by only 2 percentage points annually after the initial fixed-interest-rate period, and 6 percentage points over the life of the mortgage.
To see if an ARM is right for you, reach out to a loan officer and ask for different scenarios that factor in interest rate fluctuations.