What is an Adjustable Rate Mortgage? How Interest is Determined and When an ARM is a Good Idea 

I’ve owned my fair share of mortgages over the years, and if memory serves, that first one was adjustable. Now, interest rates were sky-high back then, and that ARM looked mighty attractive — for the first five years, anyway. 

Lucky for us, we ended up selling that house before the five years were up, so it turned out to be a smart deal. 

An adjustable-rate mortgage (ARM) is a home loan with an interest rate that can change periodically based on market conditions, typically starting with a lower fixed rate for an initial period before adjusting at set intervals.

Before you consider an ARM, know that the mortgage market can buck like a wild bronco and can be a financial burden if you’re unprepared. So, let’s dig deeper into ARMs and see when they may be the ticket to your dreams and when you may want to stay away.

Before you saddle up for an ARM, it pays to know just how this critter operates. The rate adjustments can make your payments rear up or settle down. 

So you need to understand how an ARM works to prevent being thrown for a loop.

Initial Fixed Rate Period 

ARMs often start off as smooth as a creek on a calm day, giving you a fixed rate for a set spell. Typically, this rate holds firm for three to ten years, letting you get comfortable without worrying over changes in your payments.

The initial fixed-rate period of an adjustable-rate mortgage is one of the most attractive aspects of this type of loan.

Lenders dangle this initial fixed rate to lure people in with a predictable start before the rate starts kicking up like an angry mule. With this setup, you can wade comfortably into the mortgage waters before the tide starts rising.

For buyers, this initial stretch can feel like smooth sailing — especially if you’re figuring on selling or refinancing before the adjustable part starts churning up the waters.

Adjustment Periods After the Fixed Term 

Once that fixed term rolls by, you better hang onto your hat because the interest rate may start shifting gears. Rate adjustments can be as frequent as once every year, though the interest rate can move even quicker on some of them.

Every time the rate changes, your monthly payment does, too. It goes up or (infrequently) down, depending on the new rate. That’s like being in a life raft on churning water — sometimes it’s calm; other times you’re hanging on for dear life.

So, if you’re in it for the long haul, be ready for rate swings. You may decide to ride out the adjustments because they could save you a pretty penny if interest rates dip.

Benchmark Index and Margin

An ARM’s rate doesn’t just change on a whim. It’s tied to a benchmark index and margin, like a horse to a wagon. The benchmark index in the U.S. is the Secured Overnight Financing Rate (SOFR). It replaced LIBOR (the London Inter-Bank Offered Rate), which was chased out of town in 2021 due to scandals.

SOFR derives from the U.S. Treasury repo market, so it’s a steadier, more trustworthy benchmark that doesn’t spike easily or fall prey to funny business like LIBOR used to.

The index deals with repos, which have to do with banks and big-time lenders swapping government bonds for short-term cash to ensure they’ve got enough money on hand to keep their daily businesses operating.

Then there is the margin. It’s what lenders add on top of this index to give you your final rate. While the index may jiggle around like a jumping bean, the margin remains the same for the life of the loan. 

Lenders tack on the fixed margin to the current index rate to set your new rate for each adjustment period. It’s a good idea to monitor the index so that you can be ready for your rate’s next adjustment.

When you go shopping for an ARM, knowing the lay of the land can help you avoid surprises and pick the one that best fits your needs. 

Each type of ARM has its quirks. The right choice can make all the difference between sailing in calm waters or rough seas. 

Hybrid ARMs

Hybrid ARMs start smoothly because the interest rate is fixed. You’re enjoying the first leg of your journey on a paved road until you hit gravel.

In one kind of hybrid variety, you get to enjoy a fixed interest rate for a certain number of years — often three to 10 — before it jumps into adjustable territory.

The loans come in varieties like 5/1, 7/1, and 10/1 ARMs, where the first number shows how many years are at a fixed rate, and the second is how frequently the rate changes afterward. For instance, a 5/1 ARM stays steady for five years and then adjusts annually after that.

Hybrids work if you plan to move or refinance before the change in rate. They’re a good choice if you want to enjoy low payments at the start without committing to a long-term rate.

Interest-Only ARMs

Interest-only ARMs give you the option to pay just the interest early on, which can feel like a weight off your shoulders, especially when you’re just settling in.

During this initial period — often five to 10 years — you’re covering interest only, which makes those early payments easier on the wallet.

Lower early payments give you some wiggle room to spend or invest elsewhere, making this loan ideal if you expect to earn more down the road. If you need some breathing room at the start, an interest-only ARM can be mighty tempting.

However, when that period ends, the loan payments hit you with the full amount — interest and principal combined. That jump can feel like a kick from a mule if you’re not prepared, so be certain you’re ready for it when the time comes.

Payment-Option ARMs

Payment-option ARMs allow you to set your payment amount each month.

You have choices galore, like the buffet line at the all-you-can-eat restaurant: You might select the minimum payment one month, an interest-only payment the next, and principal-and-interest when you’re flush.

This option can be a lifesaver if your income goes up and down or if you enjoy a bit of financial freedom. That’s like the choice of a route to cut through the backwoods — you’re free to pick which way to go, but you’ve got to keep an eye on where it’s taking you. 

The risk is that if you choose those lower payments too often, you may get negative amortization. That’s a situation where what you owe starts growing instead of shrinking. It’s like trying to climb out of a hole while digging it deeper. 

Balloon-Payment ARMs

A balloon-payment ARM is an entirely different animal. It starts with lower, variable payments. That’s easy enough until it demands a payment as big and scary as a hungry brown bear at a picnic. 

During the loan term, you’ll be paying just interest, with maybe a teensy amount that barely touches the principal. Then, when the term is up, you have a balloon payment.

That’s a hefty amount, and it covers what’s left of the balance. If you aren’t prepared for it, it may feel like a meteorite striking your noggin. Under some circumstances, balloon-payment ARMs may be useful if you need to sell or refinance your home before the big payment comes due. 

On the other hand, if things do not go according to the plan, and you want to keep the house, you face a gigantic obstacle that could require a refinancing loan at the then-current rates and fees.

An interest-only ARM and a balloon-payment ARM may sound like cousins, but they’ve got some real differences. In an interest-only ARM, you’re only paying the interest for the first few years, which keeps those payments as low as a snake in a wagon rut. 

Then you start paying both the interest and the principal, jumping up your payments, but you’re still working toward paying off the loan bit by bit.

You should be financially prepared for when the balloon payment comes due, because it is a large sum of money that you must pay all at once.

Now, a balloon ARM is a horse of a different color. It may start out with low payments, too, sometimes only covering the interest. Because it’s an ARM, the rate may change during this period. However, when the loan term is up, you get hit with a whopper of a payment — the dreaded balloon. That’s one gigantic chunk of money you must pay all at once to settle the loan. 

Unless you’re ready to sell, refinance, or have that cash on hand, you might end up feeling that, with a balloon-payment ARM, you’ve bitten off more than you can chew!

When it comes to adjustable-rate mortgages, there’s plenty to like, but there are stumbling blocks along the way. Let’s stroll through the benefits to show why you might just find ARMs a real prize.

Benefits

The truth is, ARMs do have some advantages, particularly if you appreciate a deal that’s easier on the wallet at the start.

• Lower Initial Interest Rates: Generally, ARMs start with lower interest rates compared to fixed mortgages, offering a breath of fresh air for most borrowers eyeing lower monthly payments. This way of doing things conserves your money so that you can use it elsewhere. This is one of the major reasons you may like ARMs, especially if you’re not planning on keeping the loan beyond its fixed period.
• Potential for Rate Decreases: Unlike a fixed-rate mortgage, which is locked in tight, ARMs might lower your rate if the market rates fall. The economy can shift quickly — if it slows down, your payment could drop right along with it and leave you grinning. That’s the roll of the dice — and perhaps a sweet deal if it pays off.
• Flexibility for Certain Borrowers: ARMs may suit you if you don’t plan to stick around long or expect a higher income over time. If you’re moving up the career ladder, an ARM’s lower starting rate and short-term appeal can fit like a glove.

Drawbacks

Of course, ARMs have their fair share of thorns, and you need to be prepared for these before signing on the dotted line.

• Risk of Rising Payments: The one big risk associated with an ARM is rising payments. If interest rates suddenly increase, the payments pop up faster than weeds after a spring rain. You may find yourself overextended if this rate goes too high. It’s a gamble that can sometimes backfire.
• Complex Loan Terms: An ARM is not easy to wrap your head around. The small details may involve caps on adjustment, indexes, and margins. That type of language can be tricky for the average cowpoke to figure out without a little coaching.
• Prepayment Penalties and Fees: Some ARMs slap on penalties if you try to pay off the loan early — a fine for getting out of the deal too soon. These fees can muck up your plans if you were hoping to sell or refinance early, so it’s worth finding out before you join this rodeo. 

ARMs can be a good option, but they may not work for everybody. Thinking about the pros and cons will help you decide whether it’s worth signing up for one.

If you’re looking to settle down with a mortgage, it pays to know the difference between an ARM and a fixed-rate loan. Each type of loan has its twists and turns. 

Understanding them can keep you from heading down the wrong river and feeling like a duck out of water.

Stability vs. Flexibility

A fixed-rate mortgage is about as predictable as the morning crowing of your prize rooster. You’re keeping your payment steady, no matter how the economic winds blow. Now, your monthly payment can change depending on fluctuations in your property taxes or homeowners insurance premium, but your interest rate remains the same.

That stability helps you budget more confidently. You won’t have to fret over whether interest rates suddenly jump and mess with your budget.

On the other hand, ARMs have lower initial rates, allowing you to save money early on. However, they have a kicker when the rate begins to adjust. This flexibility is great if you’re thinking short-term — staying in the house only a few years or expecting your income to grow. An ARM’s initial rate can feel like a fresh breeze on a hot day until it morphs into a tornado that catches you off guard.

If you’re one of those who could stomach any change, then an ARM might fit your needs just right. But if the mere thought of changes in your monthly payments is enough to make you break out in a cold sweat, then a mortgage with a fixed rate keeps things much more predictable.

Long-term vs. Short-term Cost Considerations

Your plans for the house may also dictate whether you take a fixed-rate mortgage or an ARM. Suppose you are setting down roots for a long period. 

In that case, fixed-rate mortgages provide predictable costs, and you will not be surprised by interest rates flopping around like a fish on a hook. This is often better if you intend to stay put and would like some sort of long-term security.

ARMs can be cost-effective in the short-term, but unpredictable if you plan to stay in the home long term.

But if you’re just looking to stay a while, an ARM may save you a pretty penny over the short haul. If you’ll be needing the current roof over your head for a few years, you can make use of the low starter rate on an ARM before moving on to greener pastures.

Fixed-rate loans are more expensive upfront, but they save you from fearing that your interest rate could explode. ARMs look cheaper upfront, but that adjustable period can sneak up on you like a fox in the hen house and cost you dearly.

Refinancing Opportunities 

Refinancing offers options for both ARM and fixed-rate mortgage holders when prevailing interest rates change. In the case of an ARM, it may be refinancing — that much-needed lifeline when the initial low rate starts its uphill climb. Refinancing to a fixed rate may lock in stability when the adjustments get too wild.

Many ARM borrowers can benefit by switching to a fixed rate, especially when rates are likely to spiral upward. Refinancing this way is akin to nailing down the barn doors just before a cyclone hits, and you sleep soundly, unbothered by rates jumping all around.

Of course, refinancing comes with its set of costs, including fees, paperwork, and a bit of hoop-jumping. That’s why you must weigh the benefits in the long term. 

It’s like buying new boots — that upfront price might sting, but the comfort down the line makes it worthwhile when it’s saving you from painful hikes.

Take Julie, for example, who got a 5/1 ARM on her $500,000 homestead. That initial rate was 3% and made the payments easy as pie — only $1,686 a month during those initial five years. 

But after that fixed period expired, the rate shot up to a full 7%. She soon found herself looking at payments of approximately $2,661 every month.

If that 3% stuck around for 30 years, Julie would have paid a grand total of about $607,000, pure and simple. But as the rates climb after five years, she could end up paying more than $850,000 as higher rates continue to hop around. 

Moral of the story: Sometimes, locking in a fixed rate by refinancing (even with the extra cost) can save you from being swept up in a whirlwind of shifting payments. Knowing your options can feel like the difference between smooth side-saddle riding and galloping bareback through a briar patch! 

When the stars line up just right, an adjustable-rate mortgage-ARM can seem like a slick deal, offering lower payments upfront and a lot of flexibility if you aren’t planning on settling in for the long haul. You can put the savings an ARM provides to good use. 

But ARMs come with a twist-that may feel like you’re riding a wild bull. Rates change faster than a wink, and if you are not prepared for the rising payments, you may find yourself stretched too thin. You’ve got to weigh your short- and long-term needs if you want to make the right decision.