Home buyers might be drawn to adjustable-rate mortgages (ARMs) when interest rates are high. These loans tend to start with a lower rate than the more common fixed-rate mortgages, which can lead to lower monthly payments and make buying a home more manageable.

With talk of interest rate decreases on the horizon, some buyers may also plan to start with an ARM and then refinance with a fixed-rate mortgage later. The approach might help you save money, but here are some tips on understanding how ARMs work and the potential risks before opting for this route, from myFICO.

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1. How Adjustable-Rate Mortgages Work

Adjustable-rate mortgages (ARMs) often have a 30-year term, similar to common fixed-rate mortgages. However, as the name suggests, the interest rate can change during this time.

The ARM's interest rate depends on an index rate, such as the Secured Overnight Financing Rate (SOFR), and a margin that the lender adds to the index. Your ARM's rate and your monthly payment can change when the index moves up or down.

However, your mortgage won't change every month. Instead, ARMs start with a temporarily fixed-rate period and then periodically readjust. These terms are included in the ARM's description.

You'll see two numbers, X/Y, in the ARM's name. The X is the initial fixed-rate period, and the Y is how often the rates adjust afterward. A 7/1 ARM has a fixed rate for seven years and then adjusts once a year after that, while a 10/6 ARM has a fixed rate for 10 years and then adjusts every six months.

There are various types of ARMs available, including options with fixed rates that last three, five, seven or 10 years.

2. The Initial Rate and Rate Caps

Compare your loan offers to see how your rates and resulting costs vary with an ARM and a fixed-rate mortgage. ARMs are riskier than fixed-rate loans because your rate and payments can increase, so an ARM might not make sense unless you can save money.

Additionally, review the ARM's interest rate caps, which determine how much the loan's rate can increase during the first adjustment, additional adjustments and overall.

For example, you might have a 7/1 ARM with a 5/2/5 cap. Your interest rate could change by up to 5% at the end of the initial seven years, and then it could change by up to 2% every year. The lifetime cap — the third number — tells you the maximum your rate could increase. There may also be a minimum that the rate can't fall below if the index drops.

3. How Long You Plan to Keep the Mortgage

If you refinance an ARM before the initial fixed-rate period ends, you'll never have to deal with the rate changing. Ideally, you can buy a home with a lower-rate ARM, wait until interest rates drop and then refinance into a less-risky loan with a fixed rate.

However, picking the right initial term can be tricky. ARMs with a shorter fixed-rate period might offer the lowest rate, but you'll have to hope that rates drop quickly. A longer initial term might make sense if you're not feeling confident about rates changing, or if you plan to sell the home and move before the rate starts to change.

4. The Cost of Refinancing

Another factor that you need to consider is how much refinancing the ARM will cost. For example, if you save $200 a month on interest and it will cost $2,400 to refinance, you might want to wait at least 12 months before refinancing.

There are two main costs to consider:

• Closing costs. Your closing costs can depend on where you live, the loan amount and the lender, but it may be around 2% to 6% of the loan amount. Shop around and get several offers to see who offers you a loan with the best terms and lowest fees.
• Prepayment penalties. Some ARMs might charge you a fee if you pay off the loan within the first several years. Look for an ARM without a prepayment penalty if you plan on refinancing.

Use the monthly mortgage payment calculator to see how much an ARM might save you, and compare the results to the potential cost of refinancing.

5. What Happens if Interest Rates Don't Drop

Interest rates might be higher than in recent years, but that doesn't mean they're destined to drop. If you're considering an ARM, think through what you'll do if interest rates increase.

For example, calculate what your payment would be if the rate increases to the ARM's lifetime cap. You could lose your home if you can't afford the higher payment, which might be a bigger risk than you want to take on.

Keep in mind, rising interest rates could coincide with other factors that make paying your mortgage or selling your home more difficult.

6. Your Eligibility for Refinancing

Similar to getting a mortgage to buy a home, your eligibility could depend on your income, employment history, debt-to-income ratio, home equity and FICO® Scores. And even if you can easily qualify for a mortgage today, your plan could go awry if you have trouble refinancing later.

Some of these factors might be outside your control, such as a layoff or medical emergency. However, if you plan on taking out other large loans or leaving your job and starting a business, that might make refinancing more difficult.

Get Your Credit Ready

An excellent FICO® Score can help you qualify for the lowest rates when you buy a home and refinance your mortgage. Review your credit and see if there are any ways to improve your FICO Scores, such as paying down revolving credit card balances. You may also want to avoid applying for other loans or credit cards in the months leading up to your mortgage application.

About myFICO

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