Adjustable-Rate Mortgages Make a Comeback

What Is an Adjustable-Rate Mortgage, or ARM?

Adjustable rate mortgages (ARMs) are a type of conventional mortgage in which borrowers pay a fixed rate for a number of years, and then a variable rate for the remaining mortgage payments thereafter.

The most common type of ARM is known as a 5/1 ARM. With this arrangement, the homeowner pays a fixed interest rate during the first five years of a 30-year mortgage, and then a variable rate that can adjust once yearly for the remaining term of the mortgage. (There are other types of ARMs with fixed-rate periods of two, seven and 10 years as well.)

Once the variable-rate period begins, the mortgage’s rate will adjust based on market interest rates, just as most credit cards do today. These adjustments may result in homeowners paying more or less than they were during the initial fixed-rate period.

In most cases, the initial fixed rate on an ARM will be lower than the rate the borrower could get from a comparable 30-year fixed-rate mortgage. Over the past 15 years, the fixed-rate portion of a 5/1 ARM has been roughly 0.5 to 1.5 percentage points lower than a conventional 30-year mortgage.

Average Fixed-Rate and Adjustable-Rate Mortgage Rates

How Does an Adjustable-Rate Mortgage Work?

A 5/1 ARM, for example, has a fixed-rate period of five years where the annual percentage rate is usually lower than what the same borrower might receive for a fixed-rate loan on the same property.

But after those five years of fixed-rate payments, the variable-rate period begins. The new rate will be the sum of two values, a base interest rate based on a market index plus a margin—often 2.75 percentage points, but it can vary. For example, in May 2023, many 5/1 ARM variable rates were 4.75%, plus another 2.75 percentage points, or 7.50% APR.

Monthly payment amounts are based on this two-ingredient formula and are recalculated―annually, in this case―for the life of the ARM. The “1” in a 5/1 ARM refers to how often the interest rate adjusts—once per year. (Some other types of ARMs are calculated more frequently.) The new rate can be higher or lower than it was during the fixed-rate period, but ARMs have caps, which limit how much the rate can rise at once or over the life of the mortgage.

ARMs sometimes have other features, such as the potential to convert to a fixed-rate mortgage rate. It’s a lot for consumers to take in, so lenders are required to give a plain English guide to those applying for an ARM, complete with hypothetical scenarios and monthly payments for each type of ARM a consumer applies for.

ARMs Get More Popular When Rates Are Higher

Today, for most current homeowners already with a fixed-rate mortgage, refinancing to an ARM would make little sense. The majority of homeowners with mortgages today are paying a fixed-rate APR of less than 4%, so monthly payments for both the fixed-rate portion as well as the variable rate would cost them more than their existing mortgage.

But for those shopping for a new home and mortgage, the decision is less obvious. Home prices are still elevated and interest rates sharply higher than they were throughout the 2010s. Average monthly payments for fixed-rate mortgages have increased by nearly 50% over the past year, when mortgage rates began to increase in early 2022. So even if consumers can find the right house to purchase, high monthly payments for a fixed-rate mortgage may be a deterrent.

Two decades ago, when the average 30-year fixed-rate mortgage rate was even higher than the 6.50% seen this spring, ARMs comprised nearly half of all existing mortgages, according to data from industry observer Black Knight.

But after the 2008 recession, the mortgage landscape changed, and among other changes, tougher lending standards became the norm. Consumers, with memories of many homeowners owing more on their mortgage than their home was worth, backed away from loan products with less-than-predictable rates, like ARMs.

Moreover, throughout the 2010s, houses became less expensive to finance with fixed-rate mortgages, which fell to as low as 3% in the 2010s. So fewer consumers found ARMs attractive, since the monthly payment of the fixed-rate portion of an ARM differed little from fixed-rate monthly payments of conventional mortgages. Adjustable-rate mortgages fell out of favor, with as few as 3% of all mortgages being ARMs in 2020.

But as interest rates rose sharply, ARMs got a second look. The share of ARM originations increased from the 3% it was for much of the decade to as high as 13% in October of 2022, according to Black Knight. (As of April 2023, ARMs comprised 8% of all new mortgages.)

Also, the difference in rates between the fixed-rate portion of an ARM and a conventional mortgage is widening again. According to Freddie Mac, one of two federally backed companies that buy and sell home mortgage loans, the average 30-year fixed-rate mortgage was 6.39% as of late May 2023. Meanwhile, the average 5/1 ARM was 5.83%, a difference of 0.66 percentage points. The difference could potentially lower initial monthly mortgage payments for many American homebuyers who opt for an adjustable-rate mortgage by hundreds of dollars this year.

Are ARMs a Good Decision?

It depends on a borrower’s situation, but generally homeowners could benefit from an ARM if they expect to move before the fixed-rate portion ends, or they expect their income to increase. That way, they can enjoy their lower monthly payments during the fixed-rate period without worrying too much about rates increasing.

Even if an ARM may be a preferable alternative to a fixed-rate mortgage for some consumers, you’ll still need to be approved, just as with a conventional fixed-rate mortgage. That means lenders will still want to see that you can manage your credit and monthly expenses when deciding whether to offer you any mortgage, fixed rate or adjustable.

ARMs Are Changing, but Payments Will Remain Nearly the Same

The variable-rate portions of ARMs are changing in 2023, after years of planning. Just as variable-rate credit cards track an index as part of a formula lenders use to assess interest on card balances, ARM rates also depend on a market rate as part of how the variable-rate portion of an ARM is calculated.

But instead of using the prime rate, which is what many variable-rate credit card lenders use, adjustable-rate mortgages will track something called the Secured Overnight Financing Rate (SOFR), which has replaced a similar metric. Many adjustable-rate mortgages have already switched to the SOFR to calculate monthly borrower payments.

SOFR and Federal Funds Rates

Despite the change, the new SOFR is nearly identical to the variable rate it’s replacing, so current and future ARM borrowers will still pay roughly the same as they would have using the older calculation. The SOFR has historically remained nearly identical to a rate probably more familiar to business news watchers: the federal funds target rate, which is the main policy tool the Federal Reserve uses to manage inflation and borrowing costs.