ARMs are loans that are fixed for an initial period and then adjustable after that. A 5/1 ARM is fixed for five years, then adjusts once a year for the remaining 25. In exchange for taking on that later adjustment, you usually get a lower rate during the fixed period than a 30-year fixed offers.
There’s no such thing as a 30-year ARM
What people call a 30-year ARM is an ARM with a 30-year term. The piece that matters is the initial fixed period: 3, 5, 7, or 10 years. In theory, the shorter the fixed period, the lower the starting rate.
How the adjustment works
After the fixed period, the rate is an index plus a margin. The margin is set in your loan documents and never changes; the index moves with the market. Every ARM also has caps that limit how much the rate can move at each adjustment and over the life of the loan. I’ll walk you through the specific caps on any ARM I quote you, because they vary by lender and product.
The counterintuitive part
ARMs can be harder to qualify for than a fixed loan. Lenders often qualify you on a rate above the starting rate to account for future adjustments. Lower payment, tougher approval.
When an ARM makes sense
An ARM is a good tool if you’re confident you’ll sell or refinance before the fixed period ends, or when fixed rates are high and you expect to refinance when they come down. When fixed rates are reasonable and you plan to stay put, a 30-year fixed is usually the better answer. I’ll show you both with the payment difference and what the ARM could look like at its caps, and you decide.
ARMs and jumbo loans
On very large loan amounts, portfolio lenders (banks and credit unions that keep their loans) sometimes price ARMs better than the wholesale market. If that’s your situation I’ll say so.