Adjustable-rate mortgages: What they are and how they work

What is an adjustable-rate mortgage (ARM)?

An adjustable-rate mortgage, or ARM, is a home loan that has a fixed rate only for a predetermined period, often the first three to ten years. For the rest of the loan term, the interest rate periodically increases or decreases. This means that the monthly payments can go up or down.

Generally, the initial interest rate on an ARM mortgage is lower than that of a fixed-rate mortgage.  But because it’s impossible to predict how rates will move in the future, ARMs are best for homeowners who plan to move during the introductory, fixed-rate period.

Fixed-rate vs. adjustable-rate mortgages

The difference between fixed-rate and adjustable-rate mortgages is simple: Fixed-rate mortgages have the same rate for the life of the loan, while the rate on an ARM can adjust after the introductory period. Other than that, they work similarly: You pay them off each month, in payments that include principal and interest and sometimes homeowners insurance and property taxes.

Because of their predictability — the principal and interest portion of your payment generally doesn’t change — fixed-rate mortgages are a better choice for most people.

How does an adjustable-rate mortgage work?

Most ARMs are 30-year mortgages, just like most fixed-rate loans. But with an ARM, the 30 years are divided into two parts: The introductory period, during which the rate remains the same, and the period during which the rate can adjust.

The name of each type of ARM includes the length of its introductory period and how often the rate may adjust. For example, a 7/1 ARM has a seven-year introductory period and a rate that may adjust once per year. A 5/6 ARM has a five-year introductory period and a rate that may adjust every six months. Common types of ARMs include: 3/1, 3/6, 5/1, 5/6, 7/1, 7/6, 10/1 and 10/6. 

In general, the longer the introductory period, the closer the initial interest rate will be to what you could pay with a fixed-rate loan. You’ll typically see the lowest rates with the ARMs that have the shortest introductory periods.

What are ARM rate caps?

ARMs come with rate caps that limit how much the rate can change over certain time periods: 

• Initial adjustment cap: Limits the amount the rate can increase or decrease immediately after the introductory period, typically two or five percentage points. 
• Subsequent adjustment cap: Limits how much the interest rate can rise or fall at each additional adjustment. These caps are often one or two percentage points.
• Lifetime adjustment cap: Limits the amount the rate can rise or fall in total over the term of the ARM. Many ARMs have lifetime caps of five percentage points on rate increases, but note that the cap for decreases — or the floor — may be different, and it often prevents your rate from going lower than the one you paid initially. That is, your rate may go up substantially during your loan term, but even if rates fall by a lot, it’s unlikely you’ll pay less than you did in the first years of your loan. 

Rate caps exist primarily to protect mortgage lenders. They allow the lender to take advantage of rate increases, but they don’t equally allow you to take advantage of rate decreases.

Here’s what it looks like in practice: Say you take out a 7/1 ARM with an initial rate of 6%. If rates tend to increase during your loan term, you may find yourself paying 8% or 9% — or as much as 11%. But if rates decrease, you’ll likely be stuck at or near 6%.

How are variable rates on ARMs determined?

Most ARM rates are tied to the performance of one of three major indexes: the weekly constant maturity yield on the one-year Treasury bill, the 11th District cost of funds index (COFI) and the secured overnight financing rate (SOFR). Your loan paperwork identifies which index a particular ARM follows.

To set ARM rates, mortgage lenders take an index rate and add a stated number of percentage points, called the margin. The index rate can change, but the margin does not.

For example, if the index is 4.25% and the margin is 3 percentage points, your rate is 7.25%. If the index rises to 4.5% a year later, the interest rate on your loan will rise to 7.5%.

Adjustable-rate mortgage example

Let’s compare a 30-year, 5/1 ARM for $350,000 with a 30-year, fixed-rate conventional mortgage for the same amount. The introductory rate on the ARM is 6.10%, while the fixed rate is 6.65%. Here’s how the monthly principal and interest payment could change — or not — with each loan type:

The amount you’ll save per month with an ARM — about $126 — is small compared to the additional amount you may have to pay if rates increase. But if you sell or refinance before the rate adjusts, the ARM can save you real money. Here’s the math over four years:

That’s about $7,727 saved over four years — but only if you’re out of the loan before the rate resets. If moving or refinancing is no longer an option when the time comes, you may find yourself stuck with a variable rate you hadn’t planned to afford.

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Requirements for an adjustable-rate mortgage

While the requirements to qualify for an ARM look similar to the ones for a fixed-rate mortgage, lenders often scrutinize ARM borrowers more closely. That’s because lenders want to ensure you’ll be able to handle a payment higher than the one you’re currently making.

The requirements for an ARM include:

Minimum down payment: While many lenders allow conventional borrowers to put down as little as 3% on a fixed-rate loan, 5% is typically required for ARMs. FHA and VA ARM loans have the same down payment requirements as their fixed-rate counterparts — 3.5% and 0%, respectively.

Minimum credit score: This depends on the type of ARM. If you’re applying for a conventional ARM, it’s 620. If you’re applying for an FHA ARM, it’s 580, or 500 if you’re prepared to make a 10% down payment. VA ARMs don’t have a blanket requirement, but many lenders prefer credit scores of 620 or above.

Maximum debt-to-income ratio (DTI): Most conventional lenders cap DTI ratios at 45%. For FHA loans, it’s 43%, and for VA loans, it’s typically 41%. In all cases, lower is better.

Types of ARMs

Most ARMs follow a standard, 30-year amortization schedule, in which you pay off a portion of the interest and principal each month. However, a few types of ARMs are exceptions, and they’re substantially riskier. If you’re considering one, confirm before closing that you can afford the highest possible payment.

Interest-only ARM

Similar to interest-only, fixed-rate loans, interest-only ARMs are extremely risky products in which you pay only interest for a set period. Once that period ends, and principal payments are required, the monthly payment will increase substantially, possibly becoming unaffordable.

Keep in mind that while the monthly payments will be low during the interest-only period, you won’t build any home equity unless your home appreciates in value.

Payment-option ARM

A payment-option ARM is another risky product in which you select your own payment structure and schedule, such as interest-only; a 15-, 30- or 40-year term; or any other payment equal to or greater than the minimum payment. (The minimum payment is based on a typical, 30-year amortization with the initial rate of the loan.)

A payment-option ARM, however, could result in negative amortization, meaning the balance of your loan increases because you aren’t paying enough to cover interest. If the balance rises too much, your lender might recast the loan and require you to make much larger, and potentially unaffordable, payments.

Pros and cons of an adjustable-rate mortgage

Pros

• Lower introductory rate and monthly payments
• Build equity more quickly in the early years

Cons

• Monthly payments can rise when the introductory period ends
• Harder to budget for the long term, since you won’t know your future rate until it adjusts
• Can be harder to qualify for

What buyers should know about ARM loans today

While ARMs still make up a small share of the mortgage market, their popularity has increased over the last few years as the average mortgage rate has risen post-COVID. For example, in 2021, ARMs accounted for less than 2% of mortgage applications, compared with 8% today. Many of the households taking out ARMs now tend to be younger and higher income, with larger mortgage balances.

However, whether you should get an ARM depends on only one thing: if it will save you money. If you know for sure that you’ll move before the fixed-rate period expires, you’re likely to pay a lower rate with an ARM than you would with a comparable fixed-rate mortgage.

There are a few reasons that you might pass on an ARM even as a short-term borrower:

• You may not save that much money. Depending on your financial profile, the amount you’ll likely save right now with an ARM compared to a conventional, fixed-rate loan is relatively low. The math may be different if you’re applying for a jumbo loan.
• Your plans may change. If you end up staying past the introductory period and rates have risen, your payment can increase by hundreds of dollars a month with no guarantee market rates will be favorable if you refinance. 
• You can’t refinance on your timeline. While you may plan to refinance an ARM into a fixed-rate loan before the introductory period ends, there’s no telling what rates will be like when the time comes. Even if rates are substantially lower, refinancing costs money each time, typically between 2% and 5% of the loan amount. On a $300,000 balance, that could mean $6,000 to $15,000 in out-of-pocket costs.

Adjustable-rate mortgages can be a money-saver for some people — mostly homeowners who plan to move within the introductory period. But unless you’re in this group, it’s unlikely you’ll save with an ARM — and even if you are, you may decide an ARM isn’t worth the trouble.