What is an an adjustable-rate mortgage and how does it work?

An adjustable-rate mortgage (AJM) has a variable interest rate, meaning that rate shift over the life of the loan. Those who take out a traditional or thirty-year mortgage lock the interest rate that will be applied to their principal balance when they sign the agreement. Refinancing is an option but the borrower would need to apply to their servicer to see a decrease in their interest rate. ARMs, by comparison, will offer one interest rate for the first few years of the loan, and then the bank will adjust the rate applied to the principal balance.

For example, a standard ARM is a 2/28 ARM which means a borrower will pay a fixed interest rate for the first two years of the loan, “followed by a floating rate for the remaining 28 years,” according to Investopedia. Similar schemes are available for shorter amounts of time. A 5/1 ARM allows a fixed rate to be applied to the balance for the first five years. After that period ends, a revised interest rate is used each year after.

There are also options like the interest-only ARMs, which require borrowers to only pay interest for a specific amount of time. Typically borrowers who qualify for this type of mortgage will only pay interest for anywhere between three and ten years, after which they will start to pay back the loan’s principle.

ARM popularity was on the rise

The popularity of ARM increased in recent years as the rates offered, at least when the mortgage is approved, are lower than what is offered in a traditional-rate mortgage.

The financial news outlet, Bankrate, has touted the benefits of ARMs, including that having a lower interest rate available when the loan is first given can allow borrowers to save money that can be applied to the balance when the fixed interest rate expires. In recent years, some borrowers have been able to save as much as $400 because of the historically low interest rates before 2022.

Pros and cons of an ARM

There are, however, some possible drawbacks of ARMs compared to their traditional counterpart. For example, depending on the market and the interest rates offered, the required payments to pay back the loan can increase significantly over the life of the mortgage. There is no clearer example of this as the last year, which has seen interest rates hiked a dozen times; mortgages are getting unaffordable.

Bankrate has also noted the complexity of these types of loans and that those interested should be aware that “more active and savvy in managing” will be required.

Often the rates will be subject to change every six months once the fixed-rate era ends. These loans are best for those who do not think they will hold onto the property for many years but assume that the asset will appreciate. In most cases, the rate offered for the first few years of the loan will be lower than those provided to owners receiving a fixed-rate loan.