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Are you considering an adjustable-rate mortgage? Here are the pros and cons

Fixed-rate mortgages maintain a constant interest rate; adjustable-rate mortgages work differently.

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As mortgage rates spike, more and more potential homebuyers are considering adjustable-rate mortgage loans to finance their home purchases.

Adjustable-rate mortgages, or ARM for short, operate differently from fixed-rate mortgages, which keep a constant interest rate for the entirety of the loan. They can be a bit complicated at times, so here's what you need to know about how they work, plus the pros and cons of taking one on.

How do adjustable-rate mortgages work?

An adjustable-rate mortgage is a type of loan that carries an interest rate that is constant at first but changes over time. For the first few years, you'll typically pay a low fixed interest rate. Then, once that time period is over, your interest rate will change at certain time intervals depending on market conditions.

The time periods for your low fixed rate and any associated rate fluctuations would already be agreed upon when you accept the mortgage. A 10/6 ARM means that you'll pay a fixed interest rate for 10 years, then the rate will adjust every six months. A 7/1 ARM, on the other hand, means you'll get a fixed interest rate for the first seven years, then the rate will adjust every year. Depending on market conditions, your rate can wind up being lower or higher.

Here's a look at the pros and cons of choosing an ARM over a fixed-rate mortgage.

Pros

You'll pay lower interest rates in the initial phase of the mortgage

With fixed-rate mortgages, you're locked into the same interest rate for the entire life of the loan, which is usually 15 or 30 years. But with an adjustable-rate mortgage, you start off paying a really low interest rate during what's known as the fixed period.

The fixed period can be the first five, seven or even 10 years of your loan. And because you're typically charged a lower interest rate during this time, compared to what you'd be charged with a fixed-rate mortgage, this will help you save money at least for a little while.

Your adjusted interest rates could possibly be lower

After the fixed period, you'll enter what's called the adjustment period, which lasts for the remainder of the life of the loan. This is the part where your interest rate changes at specific intervals, whether it's every six months or every year.

Your new interest rate will depend on the market — in a low interest rate environment you're likely to receive a low rate, but if interest rates have increased, your new rate is likely to be even higher. It's important to note, though, that since most adjustments come with caps, your rate won't be able to go up past a certain percentage or increase by more than a certain amount during each adjustment.

Because the adjustments depend on the market, it's possible for you to end up getting an even lower interest rate than what you started with, allowing you to save money while you pay off the loan.

It'll help you save money if you plan to move in a few years

Because this type of loan carries an interest rate that adjusts after the first five to 10 years, it makes it an attractive mortgage option for those who plan to sell their house and move before the rate adjusts to a potentially higher level. Doing this could allow you to make more affordable mortgage payments until you're ready to move.

Cons

You could struggle with a higher payment once the rate begins to adjust

One huge downside to an adjustable-rate mortgage is your rate will adjust depending on the market, so you may not always immediately know how high or low of a rate to expect — rate caps, meanwhile, will depend on your lender and the terms outlined in your loan agreement.

If you end up with a much higher interest rate during your adjustment period, there's always the risk that you won't be able to afford monthly payments because of the higher interest charge.

If it turns out you can't afford your payments and you're worried about losing your home, consider refinancing your mortgage. Similar to refinancing any other debt, this means you'd be replacing your old mortgage with a new one, ideally one with a lower interest rate. Keep in mind that you may also end up with a new balance to pay off as a result. You'll also want to begin the refinancing process when your credit score is as healthy as possible so you're more likely to be approved for the lowest interest rate.

Your financial situation could be drastically different when rates change

Similarly, there's always the chance you may encounter life situations that could impact your ability to pay a potentially higher interest rate on top of your mortgage payment. For example, switching to a lower-paying career, receiving a pay cut or taking time off work to care for family could have a major effect on your financial situation. Or, if you were to suddenly have a child (or another child) to take care of, you'd want to be sure your mortgage payments were still affordable.

You might have to pay a prepayment penalty if you sell or refinance

If you do decide to refinance your adjustable-rate mortgage to get a lower interest rate, you could be hit with a prepayment penalty, also known as an early payoff penalty. The same applies if you decide to sell your home before paying off the loan. When you sell your home or refinance for a lower interest rate, it means the lender will essentially be missing out on interest charges they would have otherwise received.

Note that not every lender charges these penalties — read through your mortgage loan terms carefully to see if they do should the situation arise.

Where to find adjustable-rate mortgages

If an adjustable-rate mortgage sounds like the best option for you, there are several lenders that offer this type of loan. Chase Bank has both fixed-rate and adjustable-rate mortgages, as well as conventional loans, Federal Housing Administration, or FHA loans, VA loans, Jumbo loans and the Chase DreaMaker℠ Mortgage Program.

Ally Bank is another option if you're in the market for an adjustable-rate mortgage. Keep in mind that while this lender doesn't offer FHA loans, USDA loans, VA loans or a home equity line of credit (also called a HELOC), you can choose from several loan terms that range from 15 to 30 years.

Chase Bank

  • Annual Percentage Rate (APR)

    Apply online for personalized rates; fixed-rate and adjustable-rate mortgages included

  • Types of loans

    Conventional loans, FHA loans, VA loans, DreaMaker℠ loans and Jumbo loans

  • Terms

    10 – 30 years

  • Credit needed

    620

  • Minimum down payment

    3% if moving forward with a DreaMaker℠ loan

See our methodology, terms apply.

Pros

  • Chase DreaMaker℠ loan allows for a slightly smaller down payment at 3%
  • Discounts for existing customers
  • Online support available
  • A number of resources available for first-time homebuyers including mortgage calculators, affordability calculator, education courses and Home Advisors

Cons

  • Doesn't offer USDA loans or HELOCs
  • Existing customers discounts apply to those who have large balances in their Chase deposit and investment accounts

Ally Bank

  • Annual Percentage Rate (APR)

    Apply online for personalized rates; fixed-rate and adjustable-rate mortgages included

  • Types of loans

    Conventional loans, HomeReady loan and Jumbo loans

  • Terms

    15 – 30 years

  • Credit needed

    620

  • Minimum down payment

    3% if moving forward with a HomeReady loan

See our methodology, terms apply.

Pros

  • Ally HomeReady loan allows for a slightly smaller downpayment at 3%
  • Pre-approval in just three minutes
  • Application submission in as little as 15 minutes
  • Online support available
  • Existing Ally customers can receive a discount that gets applied to closing costs
  • Doesn't charge lender fees

Cons

  • Doesn't offer FHA loans, USDA loans, VA loans or HELOCs
  • Mortgage loans are not available in Hawaii, Nevada, New Hampshire, or New York

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Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.