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- An ARM secures your rate for the first few years of your loan, after which it changes periodically.
- The main benefit of an ARM is that you can often snag a lower rate than you would with a fixed-rate mortgage.
- But ARMs can be risky because your monthly payment could increase if your rate goes up.
When you buy a home, you'll choose between two basic types of mortgages: a fixed-rate mortgage and an adjustable-rate mortgage, or ARM.
Here's what to know about ARMs — and when you might want to use one.
What is an adjustable-rate mortgage?
When you get a mortgage, you'll pay interest on the money you borrow. Your interest rate can be either fixed or adjustable — sometimes called variable. Here's what that means.
Definition of an adjustable-rate mortgage
An adjustable-rate mortgage has an interest rate that can change. This is different from a fixed-rate mortgage, which locks in your rate for the entire life of your loan. For example, if you have a 30-year fixed-rate mortgage, you'd pay the same rate for all 30 years.
How adjustable-rate mortgages work
With an ARM, your rate stays the same for a certain number of years, called the "initial rate period," then changes periodically. For example, if you have a 5/1 ARM, your introductory rate period is five years, and then your rate will go up or down every year. There are also ARMs that adjust every six months.
Key features of adjustable-rate mortgages
There are many types of adjustable-rate loans. Here's what they have in common:
Initial fixed-rate period
Every ARM has an introductory fixed-rate period. This is usually a few years — anywhere from three to 10 — and your rate and payment will stay the same for that entire period.
Adjustable period
After the fixed-rate period expires, your rate will start to adjust depending on where the index is at the time.
How often it adjusts depends on your terms. Some of the most common terms are 5/1, 7/1, and 10/1 ARMs, but many lenders offer shorter or longer intro periods. Some ARMs, such as 5/6 or 7/6 ARMs, adjust every six months rather than once per year.
Index and margin
ARM rates rely on two main factors: an index and margin.
An index is a tool used to measure rates. ARM rates are usually tied to an index such as the Secured Overnight Financing Rate (SOFR), the prime rate, the maturity yield of the one-year Treasury bill, or the 11th District cost of funds index.
The lender then applies a margin on top of that (it's the lender's profits). This is how it will come to your initial mortgage rate, which you'll keep for the first few years of the loan.
For instance, if you take out a 5/1 ARM with an index at 3% and a margin of 2%, your intro rate is 5%. Let's say when the intro period ends, the index has dropped to 1.5% — your rate for the following year will be 3.5% (1.5% index + 2% margin).
Rate caps
If you check the respective index and see trends are going up or down, you'll have a good idea whether your rate will increase or decrease at the next adjustment point. Your lender will also have rate caps in place that will determine how much your rate can increase each period and how high your rate can go over the life of your loan.
On some ARMs, you may have a payment cap, too.
Advantages of adjustable-rate mortgages
Adjustable-rate mortgages aren't right for everyone, and they have their own unique pros and cons. The advantages of these loans include:
Lower initial rates
ARM rates are often (but not always) lower than 30-year fixed rates. This means that while you're in the fixed-rate period of your ARM, you could have a lower monthly payment, giving you more space in your budget for other necessities.
Flexibility
Since ARMs can have lower payments at the start, they can offer more flexibility — at least toward the beginning of the mortgage. This could give you more cash to invest in other ventures or achieve other financial goals.
Potential for lower payments
If rates decrease later, your monthly mortgage payment could go down. If rates start trending down in a few years, you could potentially have a lower rate than what you started with.
Disadvantages of adjustable-rate mortgages
There are drawbacks to adjustable-rate mortgages, too. Make sure you consider these before taking out an ARM.
Interest rate increases
If mortgage rates increase, you're stuck with a higher rate. If rates are up when your ARM adjusts, you'll end up with a higher rate and a higher monthly payment, which could put a strain on your budget.
Payment uncertainty
While there are rate caps in place to protect you, that doesn't mean your rate and payment can't increase significantly over time. This can make it hard to budget and plan for and could strain your finances.
Potential for negative amortization
Some ARMs have the potential to leave you in negative amortization, which means that even when you're making payments, they're not enough to cover the interest on your loan. This happens when your rate increases, taking your payment higher than your loan's payment cap. These types of ARMs are uncommon.
Who should consider an adjustable-rate mortgage?
Whether an adjustable-rate mortgage is the right choice for you depends on how long you plan to stay in the home, rate trends, your monthly budget, and your level of risk tolerance.
Short-term homeowners
If you plan to sell your home or refinance before the ARM's introductory period is over, you shouldn't have to worry about the rate adjusting. For example, if you plan on only living in the home for around five years, you might feel comfortable taking on a 7/6 ARM, since the rate won't adjust for seven years.
But be careful with this approach. Life doesn't always go as planned, and staying in the home for an extra few years could end up costing you if your rate goes up before you're able to sell. In this situation, you might want to consider giving yourself a bigger buffer, such as getting a 10/6 ARM.
Borrowers expecting income growth
If you have a large income and are only spending a small portion of it on your mortgage payment, you might feel more comfortable getting an ARM since you have room in your budget for your payment to increase. You also might consider it if you expect your income to grow down the line.
Still, borrowers considering an ARM should always plan for the worst-case scenario. Make sure you understand the terms of the ARM you're considering, including the maximum amount your rate and payment can increase. On the loan estimate you receive from your lender, it will show you how high your monthly payment could go if your rate hits the maximum. Consider if this number is compatible with your current budget.
Individuals expecting interest rates to fall
Before getting an ARM, you should also get an idea of where rates might head in the coming years. Your mortgage loan officer can share their thoughts with you on this, but it's also a good idea to do your own research and understand what kind of trends you should be watching. Remember that no one has a crystal ball, and rates could always spike right before your ARM is set to adjust.
Common types of adjustable-rate mortgages
There are many types of ARMs. Rates will depend on your mortgage lender, but in general, lenders reward a shorter initial rate period with a lower intro rate.
5/1 ARMs
A 5/1 ARM means your rate is fixed for the first five years of the loan. After that point, your rate adjusts once per year for the rest of your loan term.
7 /1 ARMs
With a 7/1 ARM, you have a fixed rate for the first seven years of the loan. Then, your rate adjusts annually for the remainder of your loan's term.
10/1 ARMs
This is the longest type of ARM typically available. You'll have a fixed rate for the first decade, and then the rate changes once per year after that.
FAQs on adjustable-rate mortgages
An ARM has a variable interest rate, while a fixed-rate mortgage has a constant rate for the entire loan term.
The interest rate on an ARM adjusts periodically, typically once a year after the initial fixed-rate period. Some ARM rates adjust every six months.
Rate caps limit how much the interest rate can increase at each adjustment period and over the life of the loan.
It can be, especially if they plan to sell or refinance before the initial fixed-rate period ends.
Adjustable-rate mortgages have interest rates that can change over time. You have a set rate for a few years, then the rate can move up or down after that. Here's an adjustable-rate mortgage example: On a 5/1 ARM, you'd have an interest rate set for the first five years. The rate would adjust once per year after that.
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