Rule of Thumb for Adjustable-Rate Mortgages

Rules to Follow as You Shop for a Variable-Rate Mortgage

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Joyce Chan / The Balance

Adjustable-rate mortgages, also known as ARMs, can be risky. After a few years at a low fixed rate, your annual percentage rate (APR) and monthly mortgage payments can then bounce around and potentially wreak havoc with your budget. 

That's why one common rule of thumb says that if you choose an adjustable-rate mortgage, it should have a fixed rate for at least as long as you plan to be in the house. That way, you can sell the home or refinance the mortgage before that dicey adjustable rate period kicks in. 

It's definitely a good rule of thumb, but it's not the be-all-and-end-all of choosing a mortgage. We'll show you the pros and cons of using this rule of thumb, including when it might not make sense to follow it. 

Key Takeaways

  • Adjustable-rate mortgages start for a few years at a low fixed rate, after which your rate can jump around in reaction to market conditions.
  • Choosing an adjustable-rate mortgage may save you money if you sell the home or refinance before the rate begins to change.
  • Adjustable-rate mortgages aren't very popular, making up just 2% of new mortgages in January 2021, according to ICE Mortgage Technology, a lending technology platform.
  • If you can't sell your home or refinance down the road, you could be trapped in an expensive and unpredictable mortgage. 

Pros and Cons of Adjustable-Rate Mortgages

To understand this rule of thumb, you'll need to know a bit about how adjustable-rate mortgages work. Here are the main points going for, and against them.

Pros
  • Cheaper at first

  • Stretches your budget

Cons
  • Unpredictable

  • Tricky to understand

  • Can cause financial hardship

Pros Explained

  • Cheaper (at first): Interest rates on adjustable-rate mortgages start lower than fixed-rate mortgages do. This gives you a smaller monthly payment at first because you're not paying as much interest. 
  • Stretches your budget: Having this type of financing may mean you are able to afford a higher-priced home.

Cons Explained

  • Unpredictable: After the adjustable rate period begins, there's no way to predict what your monthly payments might be, or how much you'll pay in interest. This can make it tough to budget and plan for the future. 
  • Tricky to understand: Adjustable-rate mortgages are more complicated than fixed-rate mortgages. They have rules for how long the fixed rate period lasts, how the adjustable rate is calculated, how often your rate is recalculated, and may even have rate caps for how high (or how low) your rate can go. 
  • Can cause financial hardship: As you can't predict your rate, it's possible that it will go higher than what you can afford in the future. And if you're not able to refinance or sell the house, you could lose your home through foreclosure

How Does the Rule of Thumb for Adjustable-Rate Mortgages Work?

When you first start shopping for mortgages, you'll quickly notice that adjustable-rate mortgages come with a lower interest rate (for the first few years, at least). It seems like a great deal—who wouldn't want a lower interest rate? 

But to ensure you really do save money, it's best to opt out of these types of mortgages unless you're able to get rid of the mortgage before the unpredictable adjustable rate kicks in. Because most people aren't able to pay off the whole mortgage in a short period of time, that means one of two things: either sell the home, or refinance. 

Because many stay in their homes for 13 years on average—far longer than the cost-saving fixed-rate period on an adjustable-rate mortgage—most buyers instead opt for a fixed-rate mortgage, as this rule of thumb suggests. 

Only 2% of new mortgages were of the adjustable-rate variety in the first month of 2021, according to software firm ICE Mortgage Technology.  

Why the Rule of Thumb for Adjustable-Rate Mortgages Generally Works

In order for this rule of thumb to work for you, two things need to happen: First, you need to be able to get a better rate on an adjustable-rate mortgage than a fixed-rate mortgage. Second, you'll need to be able to get rid of the mortgage somehow before the fixed rate period ends. 

As for the first point, it's a pretty safe bet that you'll be able to get a lower rate on an adjustable-rate mortgage than a fixed-rate mortgage. Over the last 10 years, adjustable-rate mortgages are often 1.5 points cheaper than fixed-rate mortgages. But that's not always the case; over the past year, the rates on these two mortgage types have been neck-and-neck. 

As far as shedding the mortgage, it's also generally a safe assumption you can replace or get rid of the mortgage before the adjustable rate period begins. However, this too isn't always a given. If you lose your job or your credit tanks in the next few years, you might not be able to refinance. And if the housing market goes through a pain point, you might not be able to sell your home for a good price, or even at all, especially after factoring in closing costs. 

Grain of Salt

This rule of thumb works for many people, but not everyone. Think about where you'll be in the next five years. No one has a crystal ball, but if you think there's a good chance that you'll see a drop in income or your credit score, or if you can't (or don't want to) sell your house, then this rule of thumb might not work for you. 

If you plan on staying in your house longer-term and refinancing, there are some other things to think about. If you're in a low interest rate environment like we’re experiencing today, it could be risky to opt for a lower-interest mortgage now when rates on a fixed-rate replacement mortgage might be much higher a few years down the road.

With an adjustable-rate mortgage, you’ll miss the opportunity to lock in current low interest rates for the long haul. 

Finally, if you plan on refinancing, keep in mind that this may tack on more years of payment to the debt, unless you replace the adjustable-rate mortgage with a shorter-term home loan. If you refinance after paying your adjustable-rate mortgage for five years, for example, and you take out a 30-year mortgage at that point, it'll take five years longer to pay off your home than if you'd chosen a 30-year mortgage at the start.