What is an adjustable-rate mortgage loan (ARM)?
An adjustable-rate mortgage (ARM) is the more “spontaneous” cousin of the fixed-rate mortgage. An ARM starts out with a fixed interest rate for the introductory period, then switches to a variable rate for the remaining loan term. Adjustable-rate mortgages can be a smart path to homeownership if you plan to sell or refinance before the adjustable rate kicks in, or if you expect your income to grow in the future. Let’s go over the ins and outs of adjustable-rate mortgages.
How does an adjustable-rate mortgage loan (ARM) work?
ARMs typically start with a fixed interest rate for a predetermined period, like 3, 5 or 10 years. During this time, the rate doesn’t change, which can help make budgeting easier. After this period ends, the rate starts to adjust according to the current index, plus the margin.
The index is a baseline interest rate influenced by the broader economy. Common indices include the prime rate and the Secured Overnight Financing Rate (SOFR). The margin is an extra percentage that lenders add on top of the index rate to cover their costs and make a profit. Each lender sets their own margin, but the index rate is the same across the board.
Fortunately, ARMs come with rate caps, so your rate can only increase by a certain amount each adjustment period. Even if rates in the market surge, rate caps protect you from extreme hikes in your monthly payments.
ARM vs. fixed-rate mortgage: Key differences
| Feature | Fixed-Rate Mortgage | Adjustable-Rate Mortgage (ARM) |
|---|---|---|
| Interest Rate Stability | Consistent for life of loan | Lower initial rate, then variable |
| Monthly Loan Payments | Unchanging | Variable after initial period |
| Rate Fluctuation Protection | Long-term cost savings by avoiding fluctuating rates | Rate adjustment caps limit how much interest rates can increase |
| Recommended For | Buyers seeking financial stability | Buyers planning to move or refinance in near future |
Pros and Cons of ARMs
| Pros | Cons |
|---|---|
| Lower introductory rate than other loans | Variable rates after initial period can be difficult to budget for |
| Interest rates can decrease with market conditions | Interest rates can increase with market conditions |
| Rate caps control how much your interest rate can increase over the loan term | Can be complex in terms of requirements, fees and structure |
| Option to refinance or sell property before introductory rate ends | Typically requires down payments of at least 5% |
Is an ARM right for you?
An ARM could be right for you if you plan to sell or refinance before the rate adjustment kicks in or if you expect a growth in income to offset potential rate increases. If you’re buying in a high-rate environment, you might opt for an adjustable-rate mortgage to take advantage of a lower initial interest rate for the short-term savings. Just be sure you have an exit plan for the long haul, like selling or refinancing ahead of the rate adjustment period. Before you commit to anything, run the numbers through our Mortgage Calculator and Refinance Calculator to predict how your monthly payments could change over time with different loan terms.
Common ARM terms explained
Let’s dig into the key factors that affect your loan eligibility and the terms a lender will offer you.
ARM loan limits
Adjustable-rate loans come with specific limits that vary depending on the type of loan and the lender's guidelines. For instance, conforming ARMs are bound by limits set by government-sponsored enterprises like Fannie Mae and Freddie Mac. These limits reflect average home prices in a given area, and exceeding these limits would classify the loan as a jumbo ARM for pricier properties.
PRO TIP
Want some help figuring out how much home you can afford? Our Affordability Calculator can help you work out your ideal price range.
ARM loan interest rates
Interest rates will vary over the life of an ARM, but different types of rate caps keep them in check.
Initial adjustment cap: This cap limits how much the interest rate can increase the first time it adjusts after the fixed-rate period. It's usually higher than the subsequent caps.
Subsequent adjustment cap: This cap limits the rate change for each adjustment period after the first. This means even if the index rate spikes, the impact on your mortgage will be cushioned.
Lifetime cap: This is the maximum rate change allowed over the life of the loan. No matter what happens with the index, your interest rate can never exceed this cap.
To get a clearer picture of the current market, check out today’s current rates and compare potential loan terms.
PRO TIP
The financial index changes with the economy, so it can go up or down. The margin is a set rate added by your lender that doesn't change. Together, they determine your mortgage rate. Keep an eye on both the index and margin to help predict your future payments!
ARM loan down payments
The down payment for an ARM can vary depending on your lender, the specifics of your loan and the house you're eyeing. If you’re a first-time home buyer or eligible for certain government programs, you might even snag a lower down payment.
ARM loan mortgage insurance
Diving into an ARM loan might add mortgage insurance to your checklist, especially if your down payment is less than 20%. The added insurance acts as a little savings account for the lender, just in case you struggle to make loan payments. If saving a 20% down payment is too big of a hurdle, mortgage insurance can help you get into a home quicker and begin building equity.
The cost of this insurance varies based on your loan size, down payment and credit score. Once you hit 20% equity, you can typically ask your lender to remove mortgage insurance from your bill going forward.
ARM loan credit score
A higher score often means better loan terms, like lower initial interest rates. Why? Lenders see a high credit score as a sign that you’re a safe bet and more likely to keep up with payments.
If your credit score isn’t quite where you want it to be, don’t panic. There are still ARM options out there for you. The terms might involve a higher interest rate, but that’s just the lender playing it safe. You can use this as motivation to buff up your credit score. Even a small increase can swing loan terms in your favor. Start by keeping a close eye on your credit report, paying bills on time and chipping away at debts.
PRO TIP
New and existing Citi banking customers can enjoy a discount on closing costs or interest rates with Citi’s Mortgage Relationship Pricing program.
ARM home loan DTI
Your debt-to-income ratio DTI is a key player in loan eligibility. DTI compares your monthly debt payments to your monthly income. A lower ratio shows that you are good at managing debt, which can earn you more favorable terms. You may lock in a lower initial interest rate, making those first mortgage payments easier on your wallet.
Looking to spruce up your DTI ratio? Consider tackling high-interest debts or brainstorming ways to boost your income. These moves can polish your loan profile and improve your chances of snagging better terms.
ARM loan income requirements
When it comes income requirements, the exact numbers will depend on your lender, how much you want to borrow, your other debts and your everyday expenses. Each lender has their own recipe for what makes a perfect borrower, but they all want to be sure you can afford the home you’re striving toward.
How do I apply for an adjustable-rate mortgage?
1. Understand the terms: Unlike fixed-rate mortgages, the interest rate on an ARM can change periodically after the initial fixed period based on market conditions. This means your monthly payments can increase or decrease.
2. Check your credit score: Your credit score influences the interest rate you'll qualify for. Ensure your credit is in good shape to get the best possible terms.
3. Gather financial documents: You will need to provide various documents, including recent pay stubs, tax returns, financial statements and a list of debts and assets.
4. Get pre-approved: Getting pre-approved can give you a better idea of what you can afford. This is where programs like the Citi SureStart® Pre-Approval come in handy. This pre-approval gives you a clear picture of your purchasing power and a strong commitment to lend, which is attractive to sellers and offers a leg up in a competitive housing market.
5. Submit your loan application: Once you’ve found the right home, submit a formal application. The lender will then process your application and conduct an appraisal of the property to ensure it’s worth the loan amount.
6. Review the loan estimate: The lender will provide a loan estimate that outlines the costs of the mortgage. Review this carefully to understand all fees and the true cost of the loan.
7. Close on the loan: If everything is in order and you accept the terms, you will close the loan. This involves signing all the necessary paperwork, paying any closing costs and finalizing the mortgage agreement.
Need expert advice before you apply?