ARM Loans: Know Before You Commit

For years, adjustable-rate mortgages (ARMs) practically disappeared from the conversation, especially when interest rates were hovering near historic lows, and fixed-rate loans made perfect sense for almost everyone. But as rates climbed and stayed elevated, something interesting happened: lenders started recommending ARMs again, and more homebuyers are seriously considering them.

If you’re exploring your mortgage options right now, especially as you work toward those new year homeownership goals, you’ve probably heard about ARMs. Maybe your builder’s preferred lender suggested one, or perhaps you’re trying to make the numbers work on your dream home or investments. Either way, understanding how these loans function can save you from unwelcome surprises down the road.

What Exactly Is an Adjustable Rate Mortgage?

An ARM is a mortgage that starts with a fixed interest rate for an initial period, then adjusts periodically based on market conditions. Unlike a traditional 30-year fixed mortgage, where your rate never changes, an ARM’s rate and, therefore, your monthly payment can go up or down after that initial fixed period ends. Your rate is tied to a specific financial index, plus a margin set by your lender. When the index moves, your rate adjusts accordingly. However, there are caps that limit how much your rate can change: an initial adjustment cap that limits the first rate change after your fixed period ends, a periodic adjustment cap that limits how much the rate can change at each adjustment period, and a lifetime cap that sets the maximum rate you could ever pay over the life of the loan.

ARMs typically offer lower starting rates than fixed mortgages, often 0.5% to 1% lower, which means lower initial monthly payments and easier qualification.

Common ARMs Types

Hybrid ARMs are the most popular and are named by their structure. A 5/6 ARM, for example, means your rate is fixed for 5 years, then adjusts every 6 months after that, which works well if you plan to sell or refinance within five years. The 7/6 ARM is fixed for 7 years, with semiannual adjustments thereafter, providing more stability for mid-term plans. While the 10/6 ARM is fixed for 10 years, then adjusts every 6 months. This is closer to a fixed loan but with that lower initial rate.

Interest-Only ARMs let you pay only interest for the first 3-10 years, keeping initial payments very low. The downside here is that you’re not building any equity during that period, and when the interest-only period ends, your payment jumps significantly as you start paying principal.

Payment-Option ARMs give you multiple payment choices each month, including minimum payments that might not even cover the full interest. These are risky, as any unpaid interest gets added to your principal balance, meaning you could end up owing more than you originally borrowed.

Why Builders Love ARMs

Buying new construction? Builders often push ARMs through their preferred lenders because low initial payments help close deals faster. They’ll sweeten it with rate buydowns to make the first year or two extra affordable, but there is a catch: You must use their lender, which limits your ability to shop around for better terms. It works for them, but it might not be your best option, as this limits your ability to shop around and compare offers, and you might miss better terms available elsewhere. It’s a smart business move for builders, but it doesn’t always serve your long-term interests.

Questions to Ask Before Choosing an ARM, whether you’re working with a builder’s lender or shopping independently

• How long is your starting rate fixed? This is crucial for planning. If you know you’ll sell or refinance in five years, a 5/6 ARM might work perfectly. But if your timeline is uncertain, you’re taking on more risk.

• What’s your starting interest rate? Compare this carefully to current fixed-rate options. The savings need to be meaningful enough to justify the future uncertainty.

• How often can your rate adjust after the fixed period? Monthly adjustments create more volatility than annual ones. Semi-annual adjustments (every 6 months) are most common with hybrid ARMs.

• What are the caps on adjustments? Know the worst-case scenario. If rates spike, what’s the maximum your payment could reach? Make sure you could handle that payment if it happened. 

• What index is your rate tied to? Understanding the underlying index helps you anticipate potential rate movements based on economic conditions.

• How long do you realistically plan to keep this property? Be honest with yourself. Life changes, job situations shift, and markets fluctuate. If there’s a good chance you’ll still own this home when adjustments start, factor that risk into your decision.

ARMs make sense and could be considered if you:

• Plan to sell or refinance before adjustments begin

• Expect your income to grow in the next few years

• Believe rates will drop, and you can refinance later

• Need lower initial payments to qualify

Avoid or skip ARM if you:

• Can barely afford the initial payment

• Plan to stay long-term

• Prefer predictable payments

• Would stress about potential payment increases

Many first-time buyers use ARMs to “get in the door,” planning to refinance later. This works only if you have a backup plan in case refinancing doesn’t happen.

Shop Multiple Lenders

Never accept the first offer, especially from a builder’s preferred lender. Get quotes from at least 2-3 lenders and compare:

• Starting rates

• Adjustment caps

• Fees and closing costs

• Total loan costs over time

The Bottom Line

Do not let the low initial payments cloud your judgment; make sure this strategy fits your actual situation, not just your hopes.

In today’s market, an ARM can help buyers afford homes that fixed-rate loans make too expensive. It can work for you too, but you must understand the terms and have a realistic plan. Run the numbers and consider different scenarios. - What if rates rise, stay flat, or drop? Make sure you’re comfortable with this range of outcomes.

Questions about whether an ARM is right for you? Talk through your specific situation and run the numbers with your lender. Message me or drop a comment below if you need a lender.