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Can an Adjustable-Rate Mortgage Save You Money?

By Remar Sutton, DCU StreetWise Spokesperson
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Recently, mortgage rates have started creeping up. As fixed-rate mortgage rates edge higher, many people shopping for a new home may wonder whether they should opt for a fixed-rate mortgage that will lock in their interest rate for the term of the loan or look at other mortgage options, such as an adjustable-rate mortgage (ARM), which might save them money or offer other benefits. If you'll be mortgage-shopping in the near future, it makes sense to compare an ARM to a fixed-rate loan and other mortgage options.
What is an ARM?
An ARM is a loan with a payment that adjusts up and down based on interest rate changes. ARMs usually offer a lower initial interest rate than fixed-rate loans. The important word here is initial. By choosing an ARM, you take a risk that the interest rate will rise. Of course, there is the possibility that you may benefit from falling interest rates, too.
What factors should you look at in an ARM?
With an ARM you need to consider more than the interest rate. There are other factors that will affect your monthly payment and how it changes. Make sure you ask the following questions.
  • What is the adjustment period?
    The adjustment period is how frequently the monthly payment may be changed under the terms of the loan contract—monthly, every 6 months, annually, 3 years, 5 years, or some other length. Avoid any ARMs that change more frequently than once a year.
  • What is the index?
    This is a national publicly-available percentage on which variable-rate loan rates are based. The most common index is the yield on 52-week US Treasury Bills. The index changes over the life of the loan.
  • What is the margin?
    The margin is a predetermined amount that is added to the index to determine the interest rate for the specific ARM. The margin is fixed for the life of the loan. A common margin is 2.875%. Your “adjustable” interest rate on any ARM is determined by adding the fixed margin to the index.
  • What are the adjustment and lifetime caps?
    Caps are the maximum the interest rate on a specific loan can increase or decrease. The adjustment cap is the maximum the rate can change at each adjustment period. The most common is 2% per year. You don't want a loan with an adjustment cap higher than 2% annually. The lifetime cap is the maximum total change allowable over the life of the loan. Typical lifetime caps are 5% to 6% above or below the starting rate. Believe it or not, some ARMs don't have caps so make sure any ARM you look at has both adjustment period and lifetime caps. DCU's ARMs have a 2% adjustment cap and either a 5% or 6% lifetime cap.
  • Does the ARM have a prepayment penalty?
    A prepayment penalty is a charge to pay off the loan early. This fee is in addition to the loan amount. Don't get a mortgage with prepayment penalties. DCU doesn't charge prepayment penalties.
  • Does the ARM allow negative amortization?
    Negative amortization occurs when the loan terms allow setting a monthly payment that does not cover all the interest owed for the month. As a result, you think you're paying off your loan when you aren't—instead, the amount of interest you owe is growing. This additional interest is then added to the unpaid principal balance. Thus with each regular payment, you owe more money on your mortgage, not less. You could actually end up owing more than you originally borrowed. Stay away from loans where negative amortization is possible. DCU's ARMs don't allow for negative amortization.
Two more facts to think about. With some ARMs with adjustment caps, the monthly payment may increase even when the interest rate doesn't change. This can happen when the adjustment cap holds the interest rate below the sum of the index plus margin. Let's say, for example, that you have an ARM with our recommended 2% annual adjustment cap. But the interest rate for your ARM (index plus margin) the previous year went up 3% but has been holding steady this year. By the terms of your contract, your monthly payment for this year could be increased (adjusted up) only to reflect 2%. Although the national interest rates (index) haven't changed this year, your payment will go up to reflect the additional 1% rise from the previous year the mortgage company couldn't charge you under the adjustment cap—that process is called carryover.
The second point is some ARMs raise your rate quickly when rates go up but don't lower it quickly when rates go down. You don't want an ARM like this.
Is an ARM right for you?
Before you choose an ARM ask yourself these questions:
  • Is this your dream home or do you plan to move in a few years? The average homeowner moves or refinances every 5 to 7 years. If you plan to move within a few years, an ARM may save you money particularly if the adjustment period is longer than 1 year.
  • Will your income grow enough to cover the higher payment if the rate increases? Will you be able to afford the payment at the maximum interest rate? One of the temptations of an ARM is being able to get a larger mortgage. So, check out these figures:
  • What will the monthly payment be after 12 months if the index rate:
    — stays the same
    — goes up the maximum
    — goes down the maximum
  • What will the monthly payment be after 3 years if the index rate:
    — stays the same
    — goes up the maximum
    — goes down the maximum
  • Will you have other sizeable debt, such as school tuition or car loan, in the near future?
  • Would you rather have a stable payment than one that changes periodically? If so, then an ARM probably isn't for you.
In summary
Depending on your circumstances, an ARM may be a positive choice because it allows you to benefit when rates go down. However, the negative side is that an ARM can force you to pay more when rates go up. In general, it's worthwhile to consider them as one option—if you always do the math! They may be a good choice if you are planning to sell your home or refinance within the next 5 years.
Only you can decide if an ARM is right for you.
For additional information
DCU offers Fixed, Fixed/Adjustable, and Adjustable Rate mortgages. Read more about their mortgage programs.
StreetWise Homebuying and Mortgages
Consumer Handbook on Adjustable Rate Mortgages from the Federal Reserve Board Office of Thrift Supervision (requires Adobe Acrobat Reader)
Borrowing trouble with an adjustable-rate mortgage from Consumer Reports

So, what do you think?
If you find this review helpful, please pass the word to your friends. Also email me* with any comments or suggestions.
Remar Sutton


Prepared by Remar Sutton and Remar Sutton Associates for DCU, December 2004. All rights reserved.
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Digital Federal Credit Union
Digital Federal Credit Union
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PO Box 9130
Marlborough, MA 01752-9130
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