Why take an adjustable-rate mortgage (ARM)? Why not just take a fixed rate and not worry about what rates might do in the future?

That’s a fair question, and a good one. Adjustable rate mortgages can be a good choice for borrowers who anticipate financing a property for a relatively short period of time, say three to five years. ARMs can offer lower, “teaser” rates that are usually lower than fixed mortgage rates. And when caps are applied, an ARM may be the better overall choice.

What is an adjustable-rate mortgage (ARM)?

Adjustable-rate mortgages offer an introductory rate for a set number of years. After the introductory period ends, the home loan’s rate will adjust according to overall mortgage rates.

ARM loans typically offer introductory rates that are lower than the rates available for fixed-rate mortgages, which translates to lower monthly payments — during the initial period.

These initial “fixed” periods can range from 3, 5, 7 or even 10 years. The initial interest rate then adjusts, usually once per year. These loans (also called “hybrid ARM” mortgages) can make sense depending on your plans over the first 3 to 10 years of the loan term.

An ARM might be a good idea when…

You will be receiving a windfall

If you plan to receive a large amount of money in the next 5 years or so, an ARM might make sense. Say that you have a piece of real estate with a lot of equity that you plan to sell. Or, you will receive an inheritance. Maybe you will sell your business in 5 years.

In any of these circumstances, you could take a very low initial rate, then pay off the mortgage loan toward the end of the fixed period, before the rate changes.

You plan to sell the home early

If you plan to sell the home in the next 5 to 7 years, an ARM might be a good choice. Perhaps you are a first-time buyer looking for a smaller property, but plan to move into a bigger home as your family grows. Or your job will move you out of the area in the next few years.

In these cases, it might make sense to cash in on a lower interest rate for a few years. Just be careful that your plans are fairly certain. If they’re not, you may want a fixed-rate loan or an ARM with a very low rate along with low rate caps.

For more about how ARMs work, see our ARM primer or contact a trusted mortgage lender.

You want a tax deduction or will soon retire

You might have the cash to buy a home outright, but want a short-term loan for the mortgage interest tax deduction. Although this website does not give tax advice, it’s a fact that the mortgage interest deduction can have a big effect on the amount of taxes you pay. Check with your tax advisor.

If you make a lot of money now but will retire in 3 to 10 years, an ARM might make sense. You may be able to use the tax deduction to reduce your current adjusted gross income (AGI) thereby reducing your tax bill.

When you retire and your income decreases, you could pay off the loan amount if you no longer need the tax deduction.

Rate caps determine how much your ARM can change

An ARM has another important series of numbers that set limits on how much your loan rate can change. This series of numbers shows your rate caps.

For example, if you have an ARM with a 2/2/5 cap, your rate cannot change by more than:

• 2% after the fixed-rate period ends
• 2% for each adjustment period
• 5% over the life of the loan

So, with a 2/2/5 cap on a 5/1 ARM with an introductory interest rate of 3%, your loan’s rate:

• Would remain at 3% for the five-year introductory period
• Could reach as high as 5% after the intro rate expires
• Could increase by up to 2% at each subsequent yearly adjustment

Could never surpass 8% during the life of the loan

These lifetime caps on ARMs protect borrowers from out-of-control rate increases, but even a 5% rate increase would mean much higher monthly payments.

You’d want to refinance out of your ARM before its intro rate expires, especially during a high-rate environment.

So is an ARM for everyone?

For most home buyers, a fixed-rate mortgage will be the loan of choice since it still offers incredible interest rates and stability for the future.

With an ARM, rate adjustments can mean an eventual higher interest rate and higher monthly mortgage payment. If rates rise then you could end up with an expensive new rate (and higher loan payments) once the introductory rate period ends.

Still, there are many situations in which an ARM might make sense. Especially when interests are high, ARM rates are likely to be lower than fixed interest rates and might help aspiring buyers to become homeowners.

A mortgage professional can help you determine which type of mortgage is the best choice for you, based on your personal finances and current market conditions.