What Homebuyers Should Consider About Adjustable-Rate Mortgages (ARMs)

What Is an Adjustable-Rate Mortgage (ARM)?

An adjustable-rate mortgage (ARM) is a home loan with an interest rate that remains fixed for an initial period, typically 5, 7 or 10 years, before becoming subject to periodic adjustments. Once the fixed-rate period ends, the interest rate may increase, decrease, or remain unchanged based on a market index, a margin set in your loan terms, and limits called rate caps. ARMs may offer a lower initial rate than some fixed-rate options, though that isn't guaranteed, and your rate and monthly payment can increase after the initial period ends.

Key Takeaways

• The first number in an ARM's name (such as 5/1 or 7/6) is how many years the rate stays fixed. The second is how often it can adjust after that.
• After the fixed period, your rate is generally the index plus your margin, limited by your loan's rate caps.
• Rate caps limit how much your rate can change, but they don't prevent your rate or payment from increasing.
• An ARM may be worth considering if you expect to move or refinance before the fixed period ends, though neither is guaranteed.

How Do ARM Names Like 5/1 and 7/6 Work?

ARMs are typically identified by two numbers that explain how the loan is structured. The first number represents the number of years the interest rate remains fixed, while the second indicates how frequently the rate may adjust afterward.

For example:

• 5/1 ARM: The interest rate remains fixed for the first five years and may adjust annually afterward.
• 5/6 ARM: The interest rate remains fixed for the first five years and may adjust every six months afterward.
• 7/6 ARM: The interest rate remains fixed for the first seven years and may adjust every six months afterward.

How Is an ARM's Rate Set After the Fixed Period?

When the fixed-rate period ends, your rate is generally recalculated by adding two numbers, the index and the margin, and then applying your loan's rate caps.

What is an ARM index?

The index is a market-based benchmark interest rate that moves up and down with broader market conditions. Many ARMs today use the 30-day average Secured Overnight Financing Rate (SOFR) or a U.S. Treasury index. Your loan documents identify which index your loan uses.

What is an ARM margin?

The margin is a set number of percentage points added to the index. It's established in your loan terms and generally doesn't change for the life of the loan. Because the margin stays the same, changes in your rate at each adjustment come from movement in the index, within the limits of your caps.

What are ARM rate caps?

Rate caps limit how much your interest rate can change. Many ARMs have three:

• Initial adjustment cap: the most your rate can change at the first adjustment.
• Subsequent adjustment cap: the most your rate can change at each adjustment after that.
• Lifetime cap: the most your rate can increase above your initial rate over the life of the loan.

Caps are often written as three numbers. A 2/1/5 cap structure, for example, means your rate can change by up to 2 percentage points at the first adjustment, up to 1 percentage point at each adjustment after that, and no more than 5 percentage points above your starting rate over the life of the loan. Caps limit how much your rate can change, but they don't prevent your interest rate or monthly payment from increasing over time.

Some ARMs also have a floor, a minimum rate your loan can't go below, which is set in your loan terms.

ARM vs. Fixed-Rate Mortgage: What's the Difference?

Depending on the loan program and market conditions, ARMs may offer lower initial interest rates compared to certain fixed-rate mortgage options. However, lower initial rates are not guaranteed, and borrowers should consider the possibility of future interest rate and monthly payment increases.

Both adjustable-rate and fixed-rate mortgages have advantages and considerations. The main differences include how interest rates and monthly payments work over time.

Adjustable-Rate Mortgage (ARM)

Interest rate: Remains fixed for an initial period, then may adjust at set intervals.

Monthly principal and interest payment: Can increase or decrease after the initial fixed-rate period.
Starting rate: May be lower than some fixed-rate mortgage options, though this isn't guaranteed.

May suit buyers who: Expect to move or refinance before the initial fixed-rate period ends and can manage potential payment increases.

Key consideration: Interest rates and monthly payments can increase after the fixed-rate period ends.

Fixed-Rate Mortgage

Interest rate: Remains the same for the life of the loan.

Monthly principal and interest payment: Stays consistent, although property taxes and insurance costs may change.

Starting rate: Is established at the beginning of the loan and remains unchanged throughout the loan term.

May suit buyers who: Plan to stay in their homes long term or prefer predictable monthly principal and interest payments.

Key consideration: If market interest rates fall, refinancing is generally necessary to obtain a lower mortgage rate.

Why Might Homebuyers Consider an ARM?

An adjustable-rate mortgage may appeal to homebuyers whose housing needs or financial circumstances are expected to change over time.

For example, buyers who anticipate relocating for work, purchasing a starter home, or moving into a larger home as their family grows may want to consider an ARM, particularly if they expect to sell before the initial fixed-rate period ends. However, selling or refinancing before the rate adjusts is not guaranteed, and borrowers should consider their ability to manage potential payment increases.

Other buyers are drawn to the possibility of a lower initial interest rate during the fixed period. If that's your reason for considering an ARM, it's important to understand how your rate and payment could change at each adjustment.

Adjustable-Rate Mortgage FAQs

Can an ARM's interest rate go down?

Yes. If the index falls, your rate may decrease at an adjustment, subject to your loan's caps and any floor. Your rate can also stay the same or increase, depending on where the index is at each adjustment.

What happens when my ARM's fixed-rate period ends?

Your rate is recalculated using the index plus your margin, within your caps, and your monthly payment is adjusted to match. Federal rules require your servicer to notify you about seven to eight months before the first payment at the new rate is due, and to send notices before later payment changes.

Can I refinance an ARM into a fixed-rate mortgage?

You may be able to, but refinancing isn't guaranteed. It depends on your credit, income, home value and market rates at the time, and refinancing generally involves closing costs.

What's the difference between a 5/1 ARM and a 7/6 ARM?

A 5/1 ARM has a five-year fixed period and may adjust once a year after that. A 7/6 ARM has a seven-year fixed period and may adjust every six months after that. A longer fixed period gives you more time at your initial rate, and rates and terms vary by product.

Do ARMs have prepayment penalties?

Federal rules generally prohibit prepayment penalties on adjustable-rate mortgages. Your Loan Estimate shows whether any loan you're offered has a prepayment penalty.
Is an ARM riskier than a fixed-rate mortgage?

An ARM carries more payment uncertainty because your rate can change after the fixed period. Whether that trade-off makes sense depends on how long you plan to keep the loan, your budget and your comfort with possible payment changes.

Is an Adjustable-Rate Mortgage Right for You?

Each homebuyer's financial situation is different, and choosing a mortgage involves more than comparing initial interest rates. Factors such as your long-term plans, financial stability, comfort with potential payment changes, and available loan terms can all play a role in determining which mortgage option may be appropriate.

Since homeownership plans and market conditions can change, it's important to understand the terms of your mortgage and how future adjustments could affect your budget.

Questions to ask your loan originator about an ARM:

• How long is the fixed-rate period, and how often can the rate adjust after that?
• Which index does the loan use, and what is the margin?
• What are the initial, subsequent and lifetime caps?
• Is there a floor on how low the rate can go?
• How could my monthly payment change at the first adjustment?

Connect with one of our licensed Mortgage Loan Originators to learn more about available mortgage programs and explore which options may be right for you.

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