How ARM rates work: 3/1, 5/1, 7/1 and 10/1 mortgages

Gina Freeman
Gina Freeman
The Mortgage Reports Contributor
August 25, 2022 - 8 min read

ARM rates are low for buying and refinancing

Adjustable-rate mortgages, or ARMs, have been largely ignored for years. But home buyers are changing their tune. Borrowers who buy or move in the near future could enjoy an ARM’s low rates and lower monthly payments.

As fixed-rate mortgages become more expensive and home prices continue to rise, expect to see ARM rates attract a new following. Here’s how ARM rates work, and how they affect your home buying power.


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What is an adjustable-rate mortgage?

An adjustable-rate mortgage is a type of mortgage loan with an interest rate that adjusts or changes, up and down, as it follows wider financial market conditions. When your ARM adjusts to a higher rate, your monthly payment increases. When the loan adjusts to a lower rate, your payment will decrease.

Almost all ARM loans today are “hybrid ARMs.” These have an initial period of 3-10 years where the interest rate is fixed. In fact, these initial introductory rates — sometimes called “teaser rates” — are often lower than those of a fixed-rate loan.

But at the conclusion of the initial fixed-rate period, ARM rates begin to adjust until the loan is refinanced or paid in full. These rate adjustments follow a set schedule, with most ARM rates adjusting once per year. But some ARM loans reset every six months or only once every five years.

In this way, an adjustable-rate mortgage works differently than one with a fixed interest rate. A fixed-rate mortgage (FRM) has a rate that stays the same over the life of the loan. Its rate will never increase or decrease, which also means your mortgage payment will never change.

How ARM loans work

Adjustable-rate mortgages are named for how they work, or rather, when their rates change. As an example, the most popular type of loan is a 5/1 ARM.

  • A 5/1 ARM has a fixed interest rate during the first five years. That’s what the “5” indicates
  • Afterward, the interest rate changes each year. That’s what the “1” indicates

Keep in mind that a 5/1 ARM (and most other ARM loans) still have a total loan term of 30 years. So after the 5-year fixed-rate period, your rate can adjust once per year for the next 25 years, or until you refinance or sell the home.

Similarly, the rates of a 10/1 ARM are fixed for the first 10 years and will adjust annually for the remaining life of the loan. Whereas a 5/6 ARM has a fixed interest rate for the first five years but will adjust every six months.

Lenders generally offer 3/1 ARMs, 5/1 ARMs, 7/1 ARMs, and 10/1 ARMs.

How ARM rates work

There are a few factors that go into setting an ARM’s variable rate, so it’s important to understand what they are.

Start rate

Also referred to as a “teaser rate” or “intro rate,” your start rate is the ARM’s initial interest rate. This typically lasts 3, 5, 7, or 10 years, with a 5-year fixed intro rate being the most common. ARM start rates are frequently lower than those of a fixed-rate loan.

These introductory low rates entice buyers with lower monthly payments throughout the initial fixed period. Without these start rates, few would ever choose an ARM over an FRM. You’d be taking on extra risk without getting any reward.

The ARM’s lower start rate is your reward for taking some of the risk normally borne by the lender — the chance that mortgage interest rates may rise a few years down the road.

Margin

The interest rate on any ARM is tied to an index rate, often the Secured Overnight Financing Rate (SOFR). Your “margin” is the amount that’s added to the index rate to determine your actual rate. For instance, if the SOFR rate is 2.0% and your margin is 2.5%, your ARM interest rate would be 4.5 percent. At each rate adjustment, the lender will add your margin to your index rate to get your new mortgage rate.

Your margin will be set by several factors such as your credit score and credit history, the lender’s standard margin, and broader real estate market conditions.

Fully-indexed rate

The “fully-indexed rate” on an ARM is the highest rate your loan has the potential to reach when it adjusts. Lenders set an ARM rate cap that determines how high your fully-indexed rate could go if interest rates were to rise substantially.

Lenders typically use the fully-indexed rate to qualify you for an ARM loan, rather than the lower intro rate. This helps ensure that you’ll be able to afford your home loan even if your rate adjusts upward after its fixed period expires.

ARM rate caps

ARM interest rate caps limit the amount your interest rate can increase. There are several kinds of caps:

  • One cap applies only to the first interest rate adjustment. This limits the amount your rate can increase after the initial fixed rate expires
  • One cap applies to each subsequent rate adjustment. This limits the amount by which your rate can rise each time it adjusts
  • The final cap is a lifetime interest rate cap. This determines how high your interest rate can go over the life of the loan. Even if rates keep rising, your ARM rate can never go above its lifetime cap

Lifetimes caps can be expressed as a specific interest rate — for instance, 7.5 percent. They may also be defined as a percentage point over the start rate — for instance, five percentage points over your start rate.

ARM rate floors

Just as rate caps are put in place to protect borrowers, rate floors are there to protect lenders. The floor limits the amount your ARM rate can drop if the general rate market is falling and your rate adjusts downward.

If your mortgage loan has a floor of three percentage points, your interest rate will never drop below 3%, even if its fully-indexed rate is lower.

Types of ARMs

ARMs mostly come in three varieties. Here’s how they work:

  • Hybrid ARM: A hybrid ARM is the most common type of variable-rate mortgage. It begins with a fixed-rate period, often between three and 10 years, before the rate changes every six months or each year
  • Interest-only ARM: Only interest is paid for an initial set amount of time with this type of loan. While the interest-only period features lower monthly payments, no principal is paid off and no home equity is built until the initial period concludes. Afterward, borrowers will begin to make full principal and interest payments
  • Payment-option ARM: Borrowers choose their own payment plan. Common options are paying both principal and interest, interest-only, or an alternative minimum payment

Most modern ARM loans are hybrid ARMs. This loan type offers lower introductory rates and payments but still comes with the security of a fully-amortized schedule that starts paying down your loan balance from day one.

Compare ARM rates

As a general rule, the shorter your fixed-rate period is, the lower your interest rate will be. This is because shorter introductory periods reduce a lender’s risk if rates unexpectedly rise. Less risk will often translate into better rates for borrowers.

5/1 vs 3/1 ARM rates

The 5/1 ARM will offer a fixed interest rate for the first five years of the loan term, while the 3/1 has a fixed rate for only the first three years. Once these teaser rates expire, the ARM will reset and be subject to interest rate adjustments for the remaining 25 or 27 years of the 30-year mortgage.

The intro rate on a 3/1 ARM should be lower than the rate on a 5/1 ARM due to its shorter introductory period.

5/1 vs 7/1 ARM rates

The 5/1 ARM is virtually identical to the 7/1 ARM, except that the start rate will adjust after the first five years, rather than seven years. In addition, the intro rate on a 7/1 ARM will be higher than on a 5/1 ARM because you get to hold onto the fixed rate for a longer time.

5/1 vs 10/1 ARM rates

There is a fairly wide gulf between 5-year and 10-year ARMs. The 10/1 ARM gives you a low fixed rate for a decade and 20 potential rate adjustments, while a 5/1 ARM only locks your interest rate for five years and has 25 potential rate adjustments.

The locked-in rate for a 10/1 ARM will be higher than a 5/1 ARM. But it will provide an additional 60 regular mortgage payments. So the 10/1 may be better for borrowers who plan on staying in their homes for longer.

ARMs can affect your buying power

If you plan to buy a house or refinance a mortgage in the near future, you should consider ARM loans along with fixed-rate mortgages. The right ARM could increase the loan amount you qualify for or make it easier to buy when home prices are increasing.

Understand, however, that lenders qualify ARM borrowers differently than they do fixed-rate borrowers.

Oftentimes, lenders check your ARM eligibility based on the loan’s fully-indexed rate, which is the highest it could go after adjusting. This protects you as a borrower because it helps ensure you can afford your payments if the rate increases later on. But it also means you don’t get the benefit of qualifying at the ultra-low intro rate.

Still, that low rate equates to lower mortgage payments for the first three to 10 years of your mortgage loan. And with fixed rates on the rise, many borrowers can benefit from the low intro payments on an ARM.

How to shop for an ARM

ARM rates are more complicated than those of fixed-rate mortgages, so shopping for them is a little different also.

The easiest way to shop for an ARM loan is to choose one with a start rate period that comes close to the time in which you expect to own the home or have the loan. If you do that, you can pretty much shop for the ARM in the same way that you’d compare fixed-rate home loans.

For instance, if you expect to own your house for only three to five years, look at 3/1 and 5/1 ARMs. But if you’re unsure how long you plan to stay in the home, a 7/1 or 10/1 ARM might be a safer choice. Apply with a few mortgage lenders and see who offers the lowest rate for that type.

APR and ARM calculations

The best-laid plans can go awry, so it makes sense to see what your ARM would do if you have to hold onto it for an extra year or two. Looking at annual percentage rates, or APRs, can be helpful in determining a “worst-case” scenario for your home loan.

For instance, the APR calculation for a 3/1 ARM assumes that after the first three years, the loan increases to its fully-indexed rate, or rises as high as it’s allowed to under the loan’s terms. It also assumes you’d keep that rate for the remaining 27 years of its term.

This can help you understand what your ARM would look like if rates were to spike and stay high. But keep in mind that this scenario is unlikely and you probably won’t pay the highest possible rate over your loan term. In addition, many borrowers move or refinance before the ARM fixed-rate period is up and never have to pay the higher payments that come with a fully-indexed rate.

What are today’s ARM rates?

ARM intro rates are typically much lower than fixed interest rates. With today’s rates on the rise from their historic lows, ARMs are becoming more attractive to home buyers and homeowners alike. Talk to a mortgage lender about your home buying plans and find out if a low-rate ARM is the right decision for you.