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What is an adjustable-rate mortgage? Is an ARM the way to go in 2024?

Yahoo Personal Finance· Getty Images
Hal Bundrick
Updated 7 min read

If you're looking for a break from higher mortgage rates, you may be considering an adjustable-rate mortgage. ARMs typically have a lower initial interest rate than fixed-rate mortgages, but then shift to a variable rate later.

It's usually not a dramatically lower interest rate, though. Currently, there’s less than a 1% difference between the 30-year fixed mortgage and the rate of a 5/1 ARM, according to the Mortgage Bankers Association.

If you're looking for a strategy to earn the best mortgage rate, you might be wondering, "Is an ARM the way to go in 2024?"

Read more: How to buy a house in 2024

ARMs behave like two different mortgages rolled into one loan agreement. It begins with a fixed-rate term, usually between five and 10 years. Then it converts to a variable-rate loan, much like a credit card, with a mortgage interest rate that can change every six months or annually, depending on what term you choose.

ARMs have a small formula to decode to fully understand how they work. For example, let’s examine the “5/1” ARM:

  • The first number is the number of years for the introductory fixed-rate term. In a 5/1 ARM, that's five years.

  • The second number is the period for each adjustment after the initial term. In this case, the rate can change annually. If the second number was a “6,” the rate would vary every six months.

Read more: What all of the best mortgage lenders have in common

Adjustable-rate mortgages often have three maximums built into their variable-rate structure. These caps can put a limit on:

  1. The initial rate increase.

  2. The amount the rate can move in subsequent adjustments.

  3. The maximum rate change over the entire mortgage.

Adjustable-rate mortgages use one of a number of broad-market interest rate indexes to determine a variable rate. These indexes are regulated by financial authorities and serve as benchmark rates for many loan products.

Lenders choose an index and add a certain percentage of cushion, called a margin. Different lenders add different margin amounts, so it pays to shop for the best ARM mortgage rates like any other loan product.

Read more: First-time home buyer — What you need to know

An adjustable-rate mortgage where the initial fixed-rate period lasts for five years and then the interest rate adjusts every year thereafter.

With this ARM, the introductory fixed interest rate lasts for five years, then adjusts every six months.

With a fixed-interest rate that lasts for seven years, the 7/1 ARM then resets its variable rate annually.

The introductory fixed rate lasts for a full seven years, then the interest rate is subject to change every six months.

One of the longest-term ARMs on the market, the 10/1 maintains a fixed mortgage rate for 10 years. After that, the interest rate is variable, with possible adjustments every year.

An adjustable-rate mortgage with an interest rate that is set for a full 10 years, then is variable and subject to change every six months.

Read more: Is now a good time to buy a house? 

A payment option ARM allows you to choose to pay various portions of the principal and interest for a specified time. The borrower can pay only the interest on the loan — or some combination of the debt and interest over a number of years. You'll owe less initially but face much higher monthly payments later.

With an interest-only ARM, you'll have a lower monthly payment, but you won't be reducing the debt you owe. A lender may offer the interest-only option for the initial period of an ARM. Again, your monthly payment may skyrocket after the introductory term because your payment will consist of principal and interest.

Tip: Payment option and interest-only ARMs can result in negative amortization. That's when your monthly payment is insufficient to cover the interest due. The amount you owe will increase rather than decrease. It's probably best to avoid these ARM options.

A convertible ARM has a built-in option to convert an adjustable-rate mortgage to a fixed-rate loan, without additional closing costs. It's like having a refinance option automatically included in your loan.

One downside: The conversion opportunity is usually available after the introductory period when the ARM is set to begin intervals of rate adjustments. That limits your choice of when and at what interest rate you can refinance.

Read more: Types of mortgage loans

  • You may get a lower initial interest rate.

  • Future flexibility: You may be able to refinance or convert the loan to a lower fixed rate later.

  • Interest rate increases during the adjustment period may make your payments increasingly less affordable.

  • Budgeting for a payment that can change every six months to a year can be challenging.

  • Interest rates may be higher when you're ready to refinance to a fixed-rate mortgage.

Getting approved for an ARM is much the same as qualifying for any other mortgage. Lenders will consider your credit score, debt-to-income ratio, and payment history. Generally, you'll need a FICO score of 620 or better.

Read more: The credit score needed to buy a house

Down payment requirements are generally the same as fixed-rate mortgages. At least a 5% down payment is preferred by many lenders.

You may be anxious to get any discount you can from higher mortgage rates. An ARM may offer that, but to make an informed decision, shop multiple providers for loan offers and ask each lender:

  • How long is my initial interest rate and payment guaranteed to stay the same?

  • Will I be making sufficient principal and interest payments to pay off the loan over the term?

  • How high can the interest rate on my ARM go?

  • How high would my payment (with principal and interest) be at the maximum interest rate? (Then ask yourself, can I afford that payment if it becomes a reality?)

  • Does the loan have a conversion option? (See "Convertible ARM" above.)

  • Does the ARM have a "teaser rate" built in? If so, what will the first adjustment payment be?

Tip: A "teaser rate" provides an even lower initial interest rate, however, it does increase the likelihood that your payment will rise, whether interest rates do or not.

Dig deeper: How much house can I afford?

If you qualify, you can refinance an ARM into a fixed-rate mortgage. However, some lenders will charge a prepayment penalty if you refinance or pay off the loan during the first few years. You will also pay closing costs on the new loan.

Some borrowers may count on refinancing an ARM before their low-rate introductory period ends. However, interest rates can be hard to predict, and refinancing may not be viable when you most need it.

ARMs are most appropriate when you know you will be in a house only for a period that matches the initial interest rate. In other words, you expect to have sufficient funds to pay the mortgage off — or will move and sell the house before the adjustment period begins.

A fixed-rate loan may be a better option if you intend to stay in a home for many years. You'll have an interest rate as well as principal and interest payments that won't change.

Read more: PNC Bank mortgage review

You may be surprised to find that the published initial rates on ARMs aren't that much lower than advertised fixed-rate mortgage rates. That's why it's so important to shop multiple lenders — and get preapproved to get a good idea of the interest rates you might earn.

Tip: Be sure to note the discount points lenders are building into their loan offers to sweeten their advertised interest rates. If you ask loan providers to give you offers with zero points, you'll be comparing offers on an equal basis.