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Updated on Wednesday, February 6, 2019
Homebuyers and homeowners seeking to refinance a mortgage have varied financial goals. Many borrowers aspire to keeping their monthly housing costs as low as possible for flexibility and room for savings. For some borrowers, the desire for low payments makes an adjustable-rate mortgage, or ARM, appealing because these loans typically have a lower initial interest rate than fixed-rate loans.
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ARMs are loans with interest rates that can change, as opposed to fixed-rate mortgages. Approximately 8.9% of all closed loans in November 2018 were ARMs, according to the Origination Insight Report from Ellie Mae, a tech platform for the mortgage industry, compared with 5.6% in November 2017.
Today’s ARMs are typically hybrid ARMs, with an initial period during which your interest rate is fixed, such as five, seven or 10 years. One more unusual ARM option has a longer life.
In 2014, PenFed created a rare 15/15 ARM, a 30-year loan that has a fixed rate for 15 years and adjusts once, to a new mortgage rate for the remaining 15 years of the loan. While credit unions and other mortgage lenders offer a 15/15 ARM, they are not widely used, said Tendayi Kapfidze, chief economist of LendingTree, which owns MagnifyMoney.
What is an ARM?
In general, ARMs offer an opportunity for borrowers to pay a lower interest rate initially, which also means your mortgage payments will be lower. While this can be an advantage, you’re also taking on some risk that interest rates will rise and make your payments much higher when the loan resets.
When interest rates are rising, some borrowers opt to take on the risk of future rate increases in order to take advantage of low initial rates, Kapfidze said. Rising mortgage rates in 2018 contributed to the increased popularity of ARMs, he said, along with higher home prices, which reduced affordability.
The risk of future rate hikes, the downside of ARMs, keeps many borrowers away from the loan product. The Consumer Financial Protection Bureau in a booklet on ARMs suggested that borrowers considering an ARM ask themselves if they will be able to afford higher payments in the future, if they have other expenses looming such as a car loan or tuition payments, how long they plan to own the home and if they will make extra payments to reduce the loan balance. If you plan on selling before your initial loan period ends, you don’t need to be as concerned about rising interest rates.
In addition to evaluating an ARM in the context of your personal financial situation, you can review the provisions of each ARM put in place to prevent too much of a payment shock when the loan resets.
The interest rate for an ARM comes from a combination of an index — such as the cost of funds index, currently at 1.060% — and a margin set by the lender. For example, if the index is 1.06% and your margin is 2%, your mortgage rate will be 3.06%. The margin typically stays the same throughout your loan.
ARMs typically have several caps that prevent your rate and your payments from jumping too quickly. These caps vary from one loan to another, so it’s important to compare them when deciding on an ARM.
- Initial cap. Most ARMs limit the amount the interest rate can adjust after the initial fixed period, regardless of the change in the index. An initial cap of 1 or 2 percentage points is common.
- Subsequent cap. Similarly, future increases are also capped each time the loan resets. For example, if you have a 5/1 ARM, the mortgage rate will adjust first after five years and then it will adjust once every year.
- Lifetime cap. According to the CFPB, all ARMs must have a lifetime cap, regardless of how high interest rates rise, such as a limit of 5 percentage points.
For example, if your initial interest rate is 3.06% and your initial cap is 1 percentage point, your new mortgage rate could only go as high as 4.06%. If your subsequent cap is 2 percentage points, the rate at the next reset could be 6.06%, depending on the interest rate of the index. Your mortgage rate could never go above 8.06% if your lifetime cap is 5 percentage points.
How does a 15/15 ARM work?
While the name “15/15” may sound like the mortgage has a 15-year term, it’s really a 30-year loan with just one interest-rate adjustment after a 15-year fixed period. The reset rate will stay in place for the remaining 15 years.
Similar to other ARMs, the mortgage rate on a 15/15 ARM is tied to an index and has a margin, but because it only adjusts once, it’s considered a more conservative option than ARMs that adjust more frequently.
A 15/15 ARM shares some of the features of a traditional 30-year fixed-rate loan, such as a 30-year repayment period and fixed principal and interest payments, at least for the first 15 years. Borrowers who are nervous about ARMs with interest rates that change annually after the initial fixed period may find this longer fixed period more comfortable.
Similar to other ARMs, 15/15 ARMs have a lifetime cap. Because these loans only adjust once, that cap also functions in the same way as do the initial cap and the secondary cap. Some currently available 15/15 ARMs have a cap of 6 percentage points.
These 15/15 ARMs differ from 5/1 and 7/1 ARMs because they reset only once rather than annually after the initial fixed period. The trade-off for the reduced number of loan-rate resets and the 30-year repayment term is that 15/15 ARMs typically have a higher interest rate than short-term ARMs and 15-year loans. For example, Agriculture Federal Credit Union in Virginia recently quoted a rate of 3.75% for a 15/15 ARM, compared with 3.337% for a 5/1 ARM and 3.625% for a 7/1 ARM. Fixed-rate loans on that same day were 3.375% for a 15-year loan and 4.25% for a 30-year loan.
While the interest rate on a 15/15 ARM is a bit higher than a 15-year fixed-rate loan, the longer repayment period means that monthly principal and interest payments are significantly lower, at $1,389 for the ARM compared with $2,126 for the 15-year fixed-rate loan, assuming a loan amount of $300,000. The monthly principal and interest payment for a 30-year fixed-rate loan would be $1,476.
In addition to comparing monthly payments, borrowers should consider the amount of interest they will pay over their loan period. With a 15/15 ARM as above, you would pay $141,728 in interest during the first 15 years, a savings of $20,794 compared with the $162,522 in interest paid during that same period on the 30-year fixed-rate loan. The total interest paid on a 15-year fixed-rate loan would be $82,730.
Is a 15/15 ARM a good idea for borrowers?
As with any loan you choose, you should consider your financial goals, your plans and prospects and your current budget to make an informed decision.
A 15/15 ARM may work best for borrowers who plan to move before the loan resets, want a lower payment for the first 15 years of their loan or were considering a 15-year loan but don’t want to be tied to higher payments.
Overall, homebuyers expect to stay in their homes 15 years but often move after 10, on average. In many cases, borrowers are likely to have moved or refinanced before a 15/15 ARM loan resets. If you plan to retire and move or relocate in a decade or so, a 15/15 ARM could be a good option for you.
If you plan to pay off your loan within 10 to 15 years but want the flexibility of making lower required minimum payments, a 15/15 ARM might be a good option. You’ll get the benefit of a lower interest rate and can make extra payments to reduce or eliminate the balance before the loan resets without being tied to a higher minimum payment of a fixed 15-year loan.
The big disadvantage of a 15/15 ARM is that you only have one adjustment, which could cause payment shock. For example, if the current rate for your 15/15 ARM is 3.75%, a loan with a cap of 6 percentage points could rise to an interest rate of 9.75%.
“With a 15/15 ARM, it’s hard to know what interest rates will be 15 years from now,” Kapfidze said. “However, more than likely that loan will be paid off or refinanced, rather than reset.”
Before you choose a loan, consider your financial situation, particularly when you plan to move again and your prospects for future income or retirement. Then compare loan rates and details to see which payment and overall loan repayment strategy fits your needs best.