What Is An Adjustable-Rate Mortgage? (2024)

ARMs are long-term home loans with two periods: a fixed period and an adjustable period.

• Fixed period: During this initial, fixed-rate period (typically the first 5, 7 or 10 years of the loan), your interest rate won’t change.

• Adjustment period: This is when your interest rate can go up or down based on changes in the benchmark (more on benchmarks soon).

Let’s say that you take out a 30-year ARM with a 5-year fixed period. That would mean a low, fixed rate for the first 5 years of the loan. After that, your rate could go up or down for the remaining 25 years of the loan.

Conforming Vs. Non-conforming ARM Loans

Beyond the loan term, you’ll encounter conforming loans and non-conforming loans as you explore your ARM options.

Conforming ARM Loans

Conforming loans are mortgages that meet specific guidelines that allow them to be sold to Fannie Mae and Freddie Mac. Lenders can sell mortgages that they originate to these government-sponsored entities for repackaging on the secondary mortgage market if the mortgages conform to the funding criteria of Fannie, Freddie and the Federal Housing Finance Agency’s (FHFA) dollar limits.

If a loan doesn’t meet these specific guidelines, it will fall into the non-conforming category. But beware of the potential pitfalls before jumping into a non-conforming loan.

Non-conforming ARM Loans

There are many good reasons why borrowers may need a non-conforming mortgage. For example, you may need to take out a non-conforming jumbo loan to purchase a home in a high-cost area. If you’re considering a non-conforming ARM, be sure to read the fine print about rate resets very carefully so you understand how they work.

Conventional Vs. Government-Backed ARMs

A conventional loan is any mortgage that is not backed by a government agency, such as the Department of Veterans Affairs (VA), Federal Housing Administration (FHA) or the U.S. Department of Agriculture (USDA).

It’s important to note that if you use a government-backed loan, like an FHA ARM or a VA ARM, your mortgage will be considered non-conforming according to the rules of Fannie Mae and Freddie Mac. However, they have the full backing of the U.S. government – which might make some home buyers feel more comfortable choosing one of these loans.

ARM Rates And Rate Caps

Mortgage rates are influenced by a variety of factors. These include personal factors like your credit score and the broader impact of economic conditions. Initially, you may encounter an "initial rate" that’s much lower than the interest rate you’ll have at some point later on in the life of the loan.

The benchmark named in an ARM contract is the basis of an ARM’s rate. For example, the contract may name the U.S. Treasury or the secured overnight finance rate (SOFR) as a rate benchmark. Essentially, the benchmark will serve as the starting point of any reset calculations.

U.S. Treasury and SOFR rates are among the lowest rates possible for short-term loans to their most creditworthy borrowers, generally governments and large corporations. From that benchmark, other consumer loans are priced at a margin, or markup, to these cheapest possible loan rates.

The margin applied to your ARM depends on your credit score and credit history, as well as a standard margin that recognizes mortgages are inherently riskier than the types of loans indexed by the benchmarks. The most creditworthy borrowers will pay close to the standard margin on mortgages, and riskier loans will be further marked up from there.

The good news is that rate caps may be in place, indicating a maximum interest rate adjustment allowed during any particular period of the ARM. With that, you’ll have more manageable swings with each new rate change.

Refinancing An ARM

An ARM can be the right fit for some situations, but what if your financial circ*mstances change? You can pursue refinancing your ARM a fixed-rate mortgage to lock in more stability than an ARM can offer.

Thankfully, the process is relatively straightforward. By refinancing, you’ll take out a new loan to pay off the original mortgage. From there, you’ll start paying off the new mortgage.

Since a new mortgage is involved, you’ll need to go through many of the same steps you took when applying for your original loan. For example, you’ll likely need to provide pay stubs, bank statements and other proof of your income and debts.

Explore today’s interest rates to see if now is a good time to refinance to a fixed-rate mortgage. If rates are higher than your current ARM, it may not be the best opportunity to make the switch.