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If you’re shopping around for a mortgage, probably one of your goals is to find a rate that is as low as possible. An adjustable rate mortgage (ARM) can be a way to get a lower rate – at least initially, before the rate adjusts.
With a 10/1 variable rate mortgage, you will have the option to lock in your rate for 10 years before the interest rate changes each year. Since ARMs typically start with lower interest rates than fixed rate loans, they can be attractive options for home buyers.
Here’s what you need to know about ARM 10/1 loans:
What is an ARM 10/1 loan?
A variable rate mortgage, or ARM, is a mortgage whose interest rate can change over time.
Here’s what the two numbers say:
- The first digit: The number of years your interest rate remains fixed.
- The second number: How often will the rate adjust each year after this fixed period.
For example, with an ARM 10/1, the rate remains fixed for the first 10 years of the loan. Each year thereafter, the interest rate may adjust to reflect market rates.
One of the most popular types of ARMs is 10/1 ARMs. Although they usually have higher rates than, say, an ARM 5/1 or an ARM 7/1, they are still competitive against 30 year fixed rate loans.
Learn more: What is a mortgage rate and how do they work?
How an ARM 10/1 works
ARMs adjust over time, resulting in a lower or higher monthly payment, depending on the fluctuation in rates. Your payment changes to ensure that your mortgage is paid on time.
With a 10/1 ARM, your mortgage rate will start to change after the 10 year fixed rate period.
There are often caps on adjusting a rate up, which can save you from unmanageable monthly payments. Here’s an overview of how ARM 10/1 works:
Modification of tariffs
Adjustable rates are determined by an index, which provides a snapshot of what is happening in the market, and a margin that is added to the market rate.
Each year after your fixed rate period ends, the lender looks at the current market rates and then adds the margin amount to get your new mortgage rate and payment.
Here’s a quick rundown of how the Index and Margin make up your rate:
- Index: This is a collection of different rates in the market and is usually expressed as a weighted average. In the past, one of the most commonly used indices was the London Interbank Offered Rate (LIBOR). However, LIBOR is being withdrawn and many US lenders are considering other options, such as the guaranteed overnight rate (SOFR). Other indices that could be used are the constant maturity treasury bills (CMT) and the cost of funds index (COFI).
- Margin: You will not pay the prime market rate for your mortgage. Instead, the lender will add an additional percentage to the index to determine your rate. For example, if you have a margin of 3.25% and your rate adjusts for SOFR – and SOFR is 0.10% – your new mortgage rate would be 3.35%.
Interest rate caps
Even though your mortgage rate adjusts each year after the initial fixed 10-year period, there are limits to the increase in your mortgage rate.
Normally, rate caps follow a sequence of first adjustment, subsequent adjustments, and a lifetime cap. One of the most common cap structures is the 2/2/5 cap. Here’s how the 2/2/5 cap structure works:
- Initial adjustment cap: Your initial adjustment, represented by the first digit, is the first time the lender adjusts the rate after the end of the 10-year fixed term. In the case of the 2/2/5 cap, the rate cannot be more than two percentage points higher than your initial mortgage rate, regardless of the amount interest rate have increased since you got your home loan.
- Subsequent adjustment limit: Each year there will be another adjustment to your rate. The upper limit of this adjustment is indicated by the second number. With the 2/2/5 cap, each subsequent adjustment made cannot exceed two percentage points from the previous rate.
- Lifetime cap: Finally, the last number in your cap structure represents the total lifetime cap, based on your initial rate. In example 2/2/5, the interest rate can never be more than five percentage points above your first rate.
As you watch get a mortgage, remember that ARM 10/1 loans often have an aggregate term of 15 or 30 years. Thus, you will benefit from a fixed rate for 10 years, then, depending on the duration, your rate will change annually for the remaining five or 20 years.
Use our mortgage payment calculator to understand what your payments might look like, depending on the interest rate you have.
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To get a better idea of what you would pay each month (principal and interest only) with an ARM 10/1 versus a fixed rate mortgage, let’s go through a quick example:
Advantages and disadvantages of an ARM 10/1
You might see a more affordable monthly payment with an ARM 10/1 at the start of your loan, which could make buying a home more affordable. Refinancing before the fixed 10-year period could also save you even more on interest.
On the flip side, if you don’t refinance your ARM 10/1, you could potentially pay more interest over time if rates go up, and your budget could be strained as your monthly payment increases. .
- Relatively long fixed rate period: A 10/1 ARM has a relatively long fixed rate period, which can be attractive, especially since the average homeowner tends to move before that date.
- Could potentially pay less interest: With an ARM 10/1, you could save on interest as long as rates stay low. Another strategy, due to the length of the initial period, is to make additional payments towards the principal, reducing your balance and paying off the mortgage sooner.
- More time to refinance before the end of the initial period: Even if you decide to stay home, the longer 10-year period gives you more time to prepare. refinance your home. And you may be eligible for a favorable refinance rate down the road.
- Higher mortgage payment potential: If interest rates rise after this initial 10-year period, you might see a higher mortgage payment. Even with an interest rate cap, a higher payment could have a significant impact on your monthly cash flow.
- Possibility of globally more expensive interest: If mortgage rates go up over time and you can’t refinance, you could be paying more long-term interest, even with mortgage caps in place.
- The rate differences are not always large enough to be worth it: Depending on the lender and the situation, there might not be a big difference in the interest rate between a 10/1 ARM and, say, a 30 year fixed rate mortgage. In the long run, a slightly higher mortgage payment might be worth it to avoid potentially higher adjustments. Also consider that refinancing your mortgage often comes with closing costs this can negate past savings.
With Credible, you can find pre-qualified rates within minutes. Our online tools make it easy for you to compare all of our partner lenders and get a great rate – it’s free, and you don’t even have to leave our platform.
When to consider an ARM 10/1
When deciding if an ARM 10/1 is right for you, it’s a good idea to shop around and compare mortgage rates. Depending on how low 30-year fixed mortgage rates are, you might be better off going with an ARM 10/1.
Be sure to compare the two when shopping around before committing to a specific loan.
Another consideration is how long you think you will have the mortgage. If you think you’ll be moving again before your rate adjusts, getting an ARM 10/1 might make more sense.
You might also be able to save money on interest with an ARM 10/1 if you plan to pay off your mortgage early or refinance before the end of the initial fixed period.