Adjustable-rate mortgage guide: How ARM loans work

What is an adjustable-rate mortgage?

An adjustable-rate mortgage (ARM) is a type of home loan that offers a low fixed rate for the first few years, after which your interest rate and payment can move up or down with the market.

In a volatile market, mortgage rates can rise swiftly and with little warning. If rates go up, that means your payment will go up. However, the low introductory rate on an ARM could help lower your payment at the outset and boost your home-buying power.

So, are ARMs a good idea? Here’s what you need to know.

In this article (Skip to...)

• How ARMs work
• ARM definitions
• Adjustable vs. fixed rates
• ARM pros and cons
• When to use an ARM
• Adjustable-rate loan FAQ

How does an adjustable-rate mortgage work?

The most common type of adjustable-rate mortgage in today’s market is the hybrid ARM. Hybrid ARM loans have two distinct periods: an introductory fixed-rate period and an adjustable-rate period. During the intro period or “teaser period,” your low interest rate and payment are fixed and cannot change. After that period expires, your rate and mortgage payment can typically increase or decrease once per year depending on market conditions.

Common ARM mortgage options include the 3/1, 5/1, 7/1, and 10/1 ARM. The first number indicates your fixed-rate period. With a 5/1 ARM, you would have an introductory fixed-rate period of five years. The second number (“1”) represents how often your interest rate could adjust up or down. Using the 5/1 ARM example, after your fixed rate expires, your interest rate could adjust up or down once each year.

Most hybrid ARMs have a total loan term of 30 years. So with a 5/1 ARM, you have a 5-year intro period and then 25 years during which your rate and payment can adjust each year. Note that modern adjustable-rate mortgages come with interest rate caps that limit how high your rate can go, so the cost can’t just increase every year for 25 years. It will stop at your loan’s cap.

ARM terms defined

There are a few important terms associated with adjustable-rate mortgages. It’s important to understand what these features are and how they work, as they determine your interest rate, your payment, and how much your mortgage can fluctuate over time.

Two key factors known as “index” and “margin” determine your ARM’s interest rate.

• The index rate is a broad, market-tracking rate to which your ARM loan is tied. When it’s time for your rate to adjust, it will move up or down based on the current index rate. Most ARMs are tied to an index rate known as the Secured Overnight Financing Rate (SOFR)
• The margin is the difference between the index rate and your actual mortgage rate. It’s a specified number of percentage points that never changes. For instance, if your margin is 2% and the index rate is currently at 4%, your adjustable mortgage rate would be 6%

It’s also important to understand how adjustable mortgage rates work when it comes time for your rate to adjust. There are three kinds of “rate caps” that limit the amount your rate can increase each time it changes.

• Initial adjustment cap: This is the maximum amount your rate can increase at the first adjustment after your initial fixed-rate period ends
• Subsequent adjustment cap: This cap is the maximum amount your rate can increase at each subsequent adjustment after the initial adjustment
• Lifetime rate cap: This cap limits how much your interest rate can increase in total over the life of the loan

How ARM rate caps work

Rate caps are especially important to understand, as they limit how much your interest rate and mortgage payment can go up throughout the adjustment period of your loan. For example, rate caps for a 5/1 ARM might be shown as 2/2/5.

• The first number (“2”) represents the initial adjustment rate cap. At the first reset, in year six, your ARM rate cannot increase by more than 2%
• The second number (“2”) limits how much your rate can increase at each subsequent adjustment. So at your second adjustment, in the seventh year, your interest rate could again increase by no more than 2%
• The third number (“5”) refers to the maximum amount your interest rate can go up over the life of your loan. So your rate could not increase by more than 5% above its initial fixed rate, regardless of how high the market goes

Say your initial ARM rate was 3 percent. With a rate cap structure of 2/2/5, your rate could increase up to 5% at its first adjustment; as high as 7% at its second adjustment; and no higher than 8% over the entire life of the loan.

Keep in mind that adjustable mortgage rate don’t always increase. If the index rate to which your loan is tied has fallen by the time your loan adjusts, your rate and payment also have to potential to go down.

Adjustable-rate mortgage vs. fixed-rate mortgage

The big difference between a fixed-rate mortgage (FRM) and an adjustable-rate mortgage (ARM) is that FRMs have a fixed interest rate and payment for the entire life of the loan. When you opt for an FRM, your rate and payment can never change unless you decide to refinance into a new mortgage loan.

Fixed-rate mortgages are the most popular choice for mortgage borrowers. The stable rate and payment make FRMs a safer option for homeowners because they never risk their payments rising and becoming unaffordable. The traditional 30-year fixed-rate mortgage is the most common type of home loan, followed by the 15-year fixed-rate mortgage.

Fixed-rate mortgages make up almost the entire mortgage market when rates are low. After all, why wouldn’t you lock in an ultra-affordable rate and payment for the life of the loan? However, ARM loans often grow in popularity when rates are rising. That’s because ARM intro rates are typically lower than fixed rates. This can help borrowers lower their costs and the outset and potentially afford more expensive homes on the same budget.

Pros and cons of adjustable-rate mortgages

The pros of an adjustable-rate mortgage include:

• Lower initial rate: A lower rate means a lower mortgage payment. This frees up cash that can go towards other bills, savings, or toward your principal loan balance each month
• Bigger home buying budget: A lower intro rate could also help you afford a more expensive home. This is a major reason buyers may choose an ARM when higher fixed rates are pricing them out of the homes they wanted
• Interest will never increase beyond the cap: Knowing the limit on your rate and payment increases can help you budget properly. This can also be a determining factor for how long you’ll remain in the home. Fortunately, you can also choose to refinance your mortgage from an ARM to an FRM rather than selling

Some cons of an ARM include:

• Payments could increase: Depending on the market, your rate and payment could go up to an unaffordable level. It’s important to understand how your ARM is structured so you can budget accordingly
• Not knowing how high or low your rate could go: Rate caps limit how much your rate can rise in total. However, you won’t know exactly how much your rate and payment are going to change at each adjustment. This uncertainty can be scary for some. Make sure you can manage the potential increase in your monthly payments
• Your rate isn’t the only thing that could change: Life happens. If your financial situation changes drastically, you may not be able to afford higher monthly payments. A job loss or an increase in family size could drastically impact your ability to handle a payment increase

These pros and cons warrant careful consideration. An adjustable-rate mortgage is a great tool for many home buyers, but it also comes with serious risks that borrowers need to be prepared for.

Who should choose an adjustable-rate mortgage?

Adjustable-rate mortgages are best suited for homeowners who don’t plan on staying in their homes for more than a few years.

If you’re confident you’ll be moving before the fixed-rate period ends, an ARM could be a great choice. You’ll enjoy the perks of a cheaper introductory rate and payment, and then move before your low rate expires. If your plans change and you no longer plan to move, refinancing to a fixed-rate mortgage could be a viable option.

If you’re in the military and find yourself relocating every 4 to 5 years, for example, the lower initial rate and payments on an ARM could be a better option than a fixed-rate mortgage. An ARM can also be a great option for first-time homebuyers who plan to start a family and upsize to a bigger home within five to 10 years.

Thanks to rising mortgage rates, affordability has taken a toll on many home buyers. As a result, many would-be homeowners are considering ARMs. This allows them to still afford the home they want without having to compromise due to higher rates.

Adjustable-rate mortgage FAQ

Your next steps

Deciding between an adjustable-rate mortgage and a fixed-rate mortgage is an important consideration. As you explore your options, think about all the factors that could make an ARM ideal for your situation, or could make an ARM a challenge for you in the future.

Interest rates are on the rise. When you’ve decided which type of mortgage is best for you, reach out to a lender to get started right away.