When it comes to getting a mortgage, there is no shortage of options. But with so many choices, how do you know the mortgage setup you are choosing is the right one for your current situation and future financial goals?

Today, we'll go over everything you need to know about one popular setup - the adjustable-rate mortgage - so that you can decide if this home loan is an option worth pursuing.

What is an Adjustable-Rate Mortgage?

An adjustable-rate mortgage (ARM) is one in which the interest rate adjusts over time.

The market and cap rules dictate just how much that rate can change, which means the interest rate can increase or may even decrease.

That means that for a set period, which you'll be aware of being signing paperwork, you'll have predictable monthly installments. After that initial term has expired, the interest rate adjusts, which would impact your payments.

How Exactly Does an ARM work?

With an ARM, you'll have 30 years to pay the loan amount back if you stick with that setup for the long haul. How you pay that money back is split into two periods, which are:

  • Fixed: this is the initial period in which the interest rate will not change
  • Adjustment: this is the period of time in which the interest rate can fluctuate

To fully grasp ARMS and how they work, you'll need to understand some mortgage lingo. Common initial ARM terms are 5, 7, and 10 years. An ARM setup could look something like this:

5/1, 7/1, or 10/1

The first number represents the fixed term, the second number is the adjustment period. So for 5/1, that means you have a set interest rate for the first five years of your loan. After those five years have passed, the interest rate will adjust once per year over the remaining 25 years of the loan.

If you opted for the 7/1 setup, your fixed period is seven years, and your interest rate will adjust once per year for the next 23 years.

A 10/1 ARM is quite popular, thanks to the lengthy fixed period of ten years. After that, your interest rate will adjust once per year for the remaining 20 years of the loan.

How Much Can Rates Increase?

While it is possible for the interest rate to go down with an ARM, it's more common to see an increase, especially since the initial appeal of adjustable-rate mortgages is the low starting interest rate.

While it can seem scary to know that the interest rate on your mortgage can change, there are some protections in place for borrowers. Let's review those now.

Index

An index is the indicator that is used to calculate the adjustments on an ARM. The index rate can increase or decrease, which then goes on to influence your interest rate.

Initial Cap

This is the maximum amount that the interest rate can change for the first time, so right after the fixed period ends.

Periodic Cap

The periodic cap is the limit that the interest rate can adjust from adjustment period to adjustment period.

Lifetime Cap

The lifetime cap is how much the interest rate is allowed to increase over the life of the loan.

Reading Those Caps

In addition to understanding what terms like 5/1 mean, it's also important to know how to read the cap structure of your adjustable-rate mortgage.

The cap structure consists of three numbers and lists them in this order: the initial cap followed by the periodic cap and lastly, the lifetime cap. So your cap structure could look something like: 2/2/5.

That means that your interest rate can increase by 2% the first time it adjusts, can increase 2% with each annual increase, but is limited to increasing by no more than 5% of the initial fixed period.

Lifetime caps are great indicators of how much you may be on the hook for in the long run. If your fixed interest rate was 3%, you'd know that the interest rate can only increase up to 8% over the life of your loan.

Questions to Ask Yourself

Because of all the setup options within this setup, it's important to answer some important questions so that you can determine if an adjustable-rate mortgage is right for you and, furthermore, which setup will offer you the most benefits and protection.

When starting the mortgage process, be sure you have answers to these questions:

  • Is this a starter home or more long term?
  • Where is the market headed?
  • Do you have stable income?
  • Any big life events in the near future? Kids? Marriage? Career change?
  • Can you afford the lifetime cap of the mortgage, if it should come to that?

Ideal ARM Candidates

So, what kind of borrower is an adjustable-rate mortgage best suited for? Those who are positive they will only be in the home for a shorter amount of time than their fixed period, those who pay close attention to the market and expect rates to decrease, or those who expect a substantial increase in their income to cover any increase in interest.

Refinancing is Your Friend

The best part of obtaining a mortgage, other than becoming a homeowner? The fact that you can refinance from one type of loan to another should your current contract no longer suit you.

While there are closing costs to factor in, refinancing is a great tool for borrowers and can help save a considerable amount of money when done right.

Find Your Lender

When it comes to exploring the specific options that complement your current and future needs, no one is more helpful than a trusted lender. Team up with Lendgo, a completely free-to-use platform that connects borrowers with reputable lenders, to start comparing your mortgage options today!