Types of adjustable-rate mortgages

One size does not fit all when it comes to adjustable-rate mortgage loans. In fact, you’ll need to read the terms closely to understand what type of ARM loan you’re considering. For example:

• 5/6 ARM — With this loan, you'll pay the initial interest rate for five years, and then the interest rate will adjust every six months afterward.
• 7/6 ARM — This loan offers a seven-year period of a lower initial interest rate, with adjustments occurring every six months afterward.
• 15/1 ARM — This loan offers a 15-year period of a lower initial interest rate, with adjustments occurring each year thereafter.

There are other types of ARMs as well, including a one-year ARM in which borrowers face annual adjustments for the duration of their loan.

How an adjustable-rate mortgage works

In addition to knowing the types of ARM loans to consider, you should become familiar with a few key points to help you see how adjustable-rate mortgages work.

The first thing to focus on is the interest rate index that determines how your interest rate will change when your initial mortgage term — also referred to as the fixed-rate period — expires. The specific index tied to your loan can be found in the loan paperwork.

Common indexes used in this determination are:

• One-year Treasury bill rate
• Secured Overnight Financing Rate (SOFR)
• 11th District Cost of Funds Index (COFI)

To keep rates from increasing too much at once, ARMs include certain limits:

• Initial cap: limits how much the interest rate can change on the first adjustment.
• Periodic cap: limits how much the interest rate can change on subsequent adjustments.
• Lifetime cap: limits how much your rate can change over the life of the loan.

When to use an adjustable-rate mortgage

In three situations, an adjustable-rate mortgage is absolutely the right call, provided there are no penalties for early repayment of the loan:

1. You intend to fix and sell the home. In this case, the lower initial interest rate allows you to spend less on interest, giving you the potential of greater profits at the time of sale. Borrowers in this circumstance seek to hold onto the property for as short a time as possible before selling and moving on to their next investment — ideally, long before the first rate increase would occur.
2. You plan to sell the home and move before the initial interest rate increases. This situation often applies to military families and those who want to build equity in a home rather than renting. A 7/6 ARM loan can be best for this, but a 5/6 or a 3/6 ARM can work as well.
3. You intend to pay off the entire loan before the first potential rate increase. Some people have structured settlements, bonds set to mature and other scheduled milestones occurring in the future. These types of windfalls enable you to repay the balance of the mortgage before enduring the potential impact of an increase in your interest rate.

When to avoid an adjustable-rate mortgage

An adjustable-rate home loan is not the right solution for everyone. In fact, most people are better served with a fixed-rate mortgage from the start. This allows you to plan for reliable monthly payments for the full duration of your loan. If you don’t have plans to relocate, sell your home or pay off your loan in full within the initial loan period, you'd fare better with the stability and security a fixed-rate mortgage provides.

Adjustable-rate mortgages absolutely have their place in the larger home loan picture. But it’s important to consider an ARM with your eyes wide open. That means understanding the potential risks and pitfalls these loans provide, as well as the rewards they offer.