Loans are essential tools that allow ordinary people to make large purchases that would otherwise be cost-prohibitive. One of the most popular items is a home; the dream of home ownership is only possible for the average person, thanks to loans. One of the loans commonly used to facilitate large purchases, like homes, is an adjustable-rate loan. Here's what you need to know about adjustable-rate loans so that you can get more mileage from your money and make informed choices about the loan option that is best for you.

What is an Adjustable-Rate Loan?

As the name implies, an adjustable rate loan is one in which the interest rate for loan repayments will face adjustments over the loan term. With these types of loans, it is common for the borrower to experience a low introductory interest rate followed by changes at specific points throughout the life of the loan. A common theme is for mortgage borrowers to have between one and five years at the introductory rate, followed by adjustments every one or two years afterward. When adjustments occur, the interest rate will change in line with the current interest rates at the time of the adjustments. Interest payments will increase if the interest rate is higher than when the loan first occurred. If the interest rate is lower, interest payments will decrease.

How Does an Adjustable-Rate Loan Work?

Unlike a fixed-rate loan in which the interest rate is predetermined for the life of the loan, adjustable-rate loans are variable. What this means is that rather than having a single interest rate for the entire 30 years of your mortgage (or the full term of other types of loans), an adjustable-rate loan involves an initial interest rate – one that is often lower than that of a fixed-rate loan – followed by periodic adjustments in which the interest rate payments may go up or down according to the current interest rate. Standard ARMs include 5/1, 5/6, 7/1, 7/6, 10/1, and 10/6, where the first number represents the initial period and the second the frequency with which the rate will change after the initial period.

Each loan is unique, and you must consult your own loan's terms to understand when the first adjustment period occurs and how often new adjustments occur afterward. Adjustable-rate loans can be highly beneficial in the right situations, though everyone has better choices. The key is to walk into the loan with your eyes wide open to the potential benefits and drawbacks of an adjustable-rate loan.

Benefits

For the right individuals, an adjustable-rate loan is a savvy investment decision. This is especially true for those prepared to capitalize on the following possible benefits adjustable-rate loans offer.

• Saves money – initially. Most ARMs have a lower introductory rate than corresponding fixed-rate mortgages and loans.
• Allows borrowers to save money for other financial goals.
• The loan is refinanced every time the interest rate changes. People with fixed-rate loans must set out to refinance (and go through the inspection-appraisal-closing processes all over again) to obtain a new interest rate.
• Offers an option to refinance and choose a fixed-rate mortgage when interest rates increase. In other words, adjustable-rate loans offer greater flexibility than borrowers find with fixed-rate alternatives.

While the possible benefits appear impressive, it's also crucial to temper them with a few careful considerations.

Drawbacks

The benefits adjustable-rate loans offer excite many borrowers, especially those envisioning a little more house for the money, thanks to the lower initial interest rate. However, it is critical to keep these considerations in mind before diving into financial waters that are difficult to navigate.

• Interest rate hikes can result in stiff increases to monthly and overall interest payments. For instance, interest rates rose between early 2022 and February 2023 by more than 3.5 percent. With an average home price in the U.S. of nearly $350,000, the difference in interest payments is painful, swinging from 0.05% in early 2022, where the monthly payment on a $350,000 home would be $1,047 with a total interest payment of $26,978.89 for the life of the loan to February of 2023 where a four percent interest rate results in monthly payments of $1,670 and total interest payments of $251,544.35. The difference is more than $600 per month and over $225,000 for the life of the loan. Most families need help to afford that kind of swing. Ever. This one is harrowing because of the difference in a single calendar year.
• Complex calculations are not easy to navigate. In addition to the costliness, the complexity makes adjustable-rate swings more difficult to anticipate and predict – making long-term planning problematic.

While many families find the possible benefits of adjustable-rate mortgages and loans attractive, the drawbacks have the potential to be devastating. It takes the right circumstances to make ARMs the best option for most consumers.

Using Adjustable-Rate Loans Responsibly

The critical factor in using adjustable-rate loans responsibly is planning for long-term success. You must maintain or even improve your credit score during the "honeymoon" period so that you can refinance for better terms when that initial interest rate ends, or you need to be in a position to sell your home or pay it off before assuming the teeth of the risk these loans represent.

Alternatives to Adjustable-Rate Loans

The safest alternative to an adjustable-rate loan is a fixed-rate loan. While the initial offer may be more than you'd prefer to pay, the repayment process's long-term predictability offers a safer borrowing route unless you have a fool-proof plan for mitigating potential upswings in interest rates should they occur.