How to Budget for an Adjustable-Rate Mortgage

How Do Adjustable-Rate Mortgages Work?

An adjustable-rate mortgage (ARM), is a long-term home loan with an interest rate that changes periodically. Generally, ARMs are tied to a financial index, and your interest rate—and subsequently your monthly mortgage payment—can increase or decrease as the index rate rises or falls.

The primary benefit of adjustable-rate mortgages is the lower rate for the loan's fixed-rate period, which can make your monthly payment affordable to start out. Additionally, an ARM may lower your debt-to-income ratio (DTI), making it easier to qualify for a loan and more favorable terms. And with lower rates to start the loan term, you may be eligible for more expensive homes than you would with a fixed-rate mortgage.

ARMs Have Two Time Periods

Adjustable-rate mortgages come with two distinct periods: A fixed-rate period and an adjustment period.

• Fixed-rate period: ARM loans start with a fixed-rate period, and the loan's rate doesn't change during this time. The fixed rate typically runs for the first three, five or 10 years of the loan.
• Adjustment period: Once the introductory period ends, the ARM moves to its adjustable-rate period, which continues for the life of the loan. How often your interest rate and monthly balance change can vary widely from loan to loan, but a one-year adjustment period is common.

The most common type of adjustable-rate mortgage is the 5/1 ARM. This loan starts with a low, fixed rate for the first five years but then switches to an adjustable rate that changes annually for the remainder of its repayment term.

Rate Caps and Floors

To prevent runaway rates, ARMs usually have three types of caps that limit the amount your interest rates can increase:

• Initial adjustment cap: The first adjustment to your adjustable-rate mortgage is commonly capped at either 2% or 5% over your starting rate. That's a wide range of interest rates that can significantly impact your budget, especially if the rate climbs by 5%.
• Subsequent adjustment cap: This is the cap for the adjustments that follow the initial adjustment as dictated by the terms of your loan. The cap is usually 2%, meaning your rate can't climb more than 2 percentage points for any new adjustment.
• Lifetime adjustment cap: A lifetime cap limits the total amount your interest rate can rise during the loan term. The cap amount can vary by lender, but the most common cap is 5%, meaning your rate can't rise above five percentage points over your initial rate, and your loan may also have a similar payment cap.

Conversely, lenders may install a rate floor that limits how low your mortgage can drop. For example, if your ARM has a 3% floor, your interest rate will never fall below that mark, regardless of what the index rate is doing.

Down Payment and Credit Requirements

You'll typically need a down payment of at least 5% and a credit score of 620 or higher to qualify for a conventional ARM. You may find less stringent requirements if you apply for an FHA or VA loan or another government-backed ARM loan. Keep in mind, most lenders will require you to buy private mortgage insurance (PMI) if your down payment on a conventional loan is less than 20% of the purchase price.

How Do You Budget for Changing Mortgage Payments?

While a lower monthly payment can make a home more affordable during the fixed-rate period, the inevitable payment boosts during the adjustment period can strain your budget. With an adjustable-rate mortgage, it's wise to set some money aside in a separate account to prepare for periodic rate hikes on your home loan.

Refer to your loan contract to understand what your upcoming payments may look like. When you apply for a loan, the lender gives you a loan estimate, which includes estimated payment ranges for different periods during the life of the loan. For example, your documentation may break down your future payment amounts, which may look something like this:

• Years 1-5 (fixed-rate period): $1,200 per month
• Year 6 (adjustable-rate period): $1,100 to $1,500 per month
• Year 7 (adjustable-rate period): $1,200 to $1,700 per month
• Year 8 through Year 30 (adjustable rate period): $1,150 to $1,800 per month

Additionally, your loan estimate should include an adjustable interest rate (AIR) table, which reveals the specific caps for your loan. The AIR table details the minimum and maximum interest rates for your loan, the frequency of rate changes and the limits on rate changes. Make sure you understand the AIR table and the projected payments on your loan estimate before signing your name on a mortgage contract.

Many lenders offer a payment cap on their ARM loans, which may help to ensure your payments fall within your budget. Be aware, however, that when interest rates are rising, a payment cap could leave you with negative amortization. In this case, you could make your full payment but still owe more money each month as unpaid interest is added to your total balance.

If you can't afford your new monthly payment on your adjustable-rate mortgage, contact your loan servicer immediately to explore your options and avoid foreclosure. Also, consider contacting a housing counselor through the Department of Housing and Urban Development (HUD), who can review your situation and help determine your eligibility for any programs or assistance.

Is an Adjustable-Rate Mortgage a Good Choice?

Deciding whether you should get an adjustable-rate mortgage may depend on your goals and how comfortable you are with the loan's unpredictable rate structure. If you plan on selling the home before the adjustment period when interest rates typically rise, you could save money.

By contrast, taking out an ARM may not make sense if you plan on living in the home for many years and prefer the stability of an interest rate and monthly payment that remain the same for the entire loan term. In this case, a fixed-rate mortgage may be a better fit for you.

Pros and Cons of an Adjustable-Rate Mortgage

As with any loan, it's wise to weigh the benefits and downsides of an adjustable-rate mortgage before making a decision.

Pros of an Adjustable-Rate Mortgage:

• Your payments may be lower during the initial fixed-rate phase.
• Your payment amount could decrease if the benchmark index underpinning your ARM also falls.
• ARM loans offer the flexibility to enjoy a lower rate initially and sell the home before the adjustable rate kicks in.
• Rate and payment caps limit how much your mortgage rate and payment can go up.

Cons of an Adjustable-Rate Mortgage:

• When the introductory period ends, your interest rates switch to a "floating" rate that can go up or down with the market.
• If you're unable to sell or refinance your home when you need to, you could be at risk of falling behind on payments and losing your home.
• Your financial situation could be different when the adjustable-rate period begins, making it harder to afford the higher monthly payments.
• Your loan could include a prepayment penalty if you sell or refinance your home.

One obvious factor to consider is how much you might save during an ARM's fixed-rate period. According to Freddie Mac's Primary Mortgage Market Survey, the U.S. weekly average rates as of October 6, 2022, are 6.66% for a 30-year fixed mortgage, compared to 5.36% for a 5/1 ARM. That means the average interest rates for an ARM are 1.3% less for a 5/1 ARM compared to its fixed-rate counterpart.

The average payment for a $350,000 loan with a 6.6% fixed interest rate is $2,557.53 per month for the life of the loan. By contrast, a $350,000 ARM loan with an introductory rate of 5.36% would result in monthly payments of $2,264.96 per month before the adjustment rate period begins. In this instance, the ARM is nearly $300 less each month than the fixed-rate loan, but remember the payments during the adjustment period will likely be substantially higher.

Test out how an ARM might impact your mortgage payments on Experian's mortgage calculator:

Improving Your Credit May Qualify You for a Lower Interest Rate

Whether you opt for a fixed-rate or adjustable-rate mortgage, it's essential to understand the terms of any loan you're considering so you don't get locked into a loan that could be difficult to afford. You'll also want to shop and compare multiple lenders to ensure you find the best rates.

Remember, lenders tend to offer their best rates to borrowers with high credit scores. Consequently, you could improve your odds of scoring a low rate on a home loan by checking your credit report and credit score on Experian. You'll discover where your credit stands and how you might improve it so you can snag a lower rate on your home loan.