A 10-year adjustable-rate mortgage offers a fixed rate for the first 10 years of the loan. After that, the interest rate resets every six months. Many homeowners opt to refinance or sell their property before the rate starts to change. So why bother with an adjustable-rate mortgage at all?
Well, because during that initial fixed-rate period, ARMs often offer significantly lower interest rates than fixed-rate mortgages. With a 10-year ARM, that’s a decade’s worth of a teaser rate. Here’s what to consider if you’re thinking about a 10-year adjustable-rate mortgage.
How does a 10-year adjustable-rate mortgage work?
A 10-year adjustable-rate mortgage is a hybrid mortgage, since it has a fixed-rate period (10 years) before the rate begins adjusting. As with fixed-rate mortgages, 30 years is a common loan term, so 10-year ARMs usually come with a 20-year adjustable-rate period.
During that adjustable period, your 10-year ARM’s interest rate will rise or fall depending on prevailing mortgage interest rates. ARM interest rates are made up of the margin, which is a static base rate, and the index, which can go up or down. Lenders add the index to the margin to determine adjustable mortgage rates.
When you are looking into 10-year ARMs, you’ll see that lenders offer not only different interest rates but also differing parameters for how the loan will work. It’s not as if anything can happen once the introductory period is up. Instead, there are caps that show you how much your interest rate might change. These are often presented as sets of three numbers, like 2/2/5. These represent the three caps.
Initial cap. The first number tells you the highest your interest rate could go the first time that it adjusts. In the 2/2/5 example, it’s a 2, so the first adjustment can’t be more than 2 percentage points. If you started out with a 4% interest rate, the highest interest rate your first adjustment could bring is 6%.
Subsequent/periodic cap. There are different names for this cap, but either way, the middle number represents how much your interest rate could change each time it adjusts after that first reset. With a 2/2/5 ARM, every six months your rate can go up as much as 2 percentage points. Continuing the example, say you’re at 6% — the highest you can go from that is 8%.
Lifetime cap. The last number gives you the highest that your interest rate could go above your initial rate. Five percentage points are pretty common. With our 2/2/5 example, assuming you’d started out with a 4% introductory rate, your lifetime cap would be 9%.
Knowing these different caps can help you understand what could happen if you end up keeping your 10-year ARM beyond that initial 10 years. You can also ask adjustable-rate mortgage lenders to do the math for you and give you actual numbers for what your mortgage payment could be at different interest rates.
Depending on prevailing rates, your interest rate also could adjust downward. This actually can put ARM borrowers in the adjustable period at an advantage, because in a falling rates environment they can get an interest rate decrease without having to refinance. However, lenders may set a floor limiting how much your interest rate can fall if rates are going down.
What are the disadvantages of a 10-year ARM?
Adjustable-rate mortgages, including the 10-year ARM, aren’t a fit for every home buyer. Here are some of the drawbacks of 10-year ARMs.
Less predictability. Even knowing the caps and the floor, you don’t know exactly what your monthly mortgage payment will be after the introductory period ends. You might have decided during that 10 years that you absolutely love the house and no longer want to move — and if your budget can’t accommodate the rate increases, that could be a problem.
Expensive to leave. If you’re planning to move anyway, no big deal. But if you need to refinance to a fixed-rate loan or into a new ARM, you’ll have to factor in the cost of refinancing. Refinance closing costs can come to 2% to 5% of the loan costs, which could potentially cancel out the savings from your introductory rate.
Higher introductory rates than 5-year ARMs. While a 10-year ARM should still get you a lower intro rate than a fixed-rate mortgage, you won’t see as big a difference as you would if you got an ARM with a shorter introductory period. A 5-year adjustable-rate mortgage will often get you the lowest introductory rate. Depending on the lender and on the interest rate climate, 10-year ARM rates might not be dramatically lower than some fixed-rate loan options.
What are the advantages of a 10-year ARM?
Though you don’t get the extra-low introductory rate of a 5-year ARM, having an extra five years to work with can give you time to make some serious money moves.
Greater buying power. Putting less of your monthly mortgage payment toward interest — at least for the first 10 years — could allow you to afford a higher-priced home without changing your home-buying budget. But bear in mind that after the introductory period, you’ll have to contend with higher interest rates or find a way out of the loan. Refinancing to a different loan type is certainly an option, but closing costs can be budget-stretching, too.
Could be all the loan you’ll need. If you’re planning on living in the home for less than 10 years, you’ll get the interest rate advantages of an ARM’s fixed period but never even deal with the adjustable portion of the loan. As long as you stick with that plan, you could save over buying the same home with a different loan type. If this is your forever home, however, another kind of mortgage might make more sense.
More time to pay down principal. For the decade when you’ve got that low interest rate, you could use any “extra” money to aggressively pay down your principal. When the ARM resets, or when you decide to refinance, you’ll have a smaller mortgage balance. If you stick with the ARM, you’re paying interest on a smaller sum. Choose to refi, and your closing costs — which, again, can be 2% to 5% of the loan amount — will be lower, since you’re borrowing less.