What Is an Adjustable-Rate Mortgage (ARM)? How ARMs Work and What Buyers Should Know
When shopping for a mortgage, you may come across two main types of interest rate structures: fixed-rate mortgages and adjustable-rate mortgages (ARMs).
A fixed-rate mortgage keeps the interest rate the same for the life of the loan. An ARM, typically starts with a fixed interest rate for a specific period and then adjusts periodically based on the terms of the loan and changes in its underlying index.
Because ARMs can offer a lower initial rate than some fixed-rate options, they may be worth considering for certain borrowers. But an ARM also comes with the possibility of future rate and payment increases.
Understanding how an ARM works can help you compare your mortgage options and decide which loan structure fits your financial situation.
What Is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage (ARM) is a home loan where the interest rate can change after an initial fixed-rate period.
Most ARMs have two basic stages:
Initial fixed-rate period: Your interest rate stays fixed for a specified number of years.
Adjustment period: After the initial period ends, the interest rate can change at regular intervals according to the terms of the loan.
For example, a 5/6 ARM typically has a fixed interest rate for the first five years. After that, the rate can adjust every six months. A 5/1 ARM, by contrast, typically has a five-year initial fixed period followed by annual rate adjustments.
The exact terms depend on the specific ARM you're considering, so it's important to review the loan documents carefully.
How Do ARM Numbers Work?
ARM names usually tell you two important things:
The first number = initial fixed-rate period
The second number = how frequently the rate can adjust afterward
For example:
ARM | Initial fixed period | Adjustment frequency |
3/6 ARM | 3 years | Every 6 months |
5/6 ARM | 5 years | Every 6 months |
5/1 ARM | 5 years | Once per year |
7/6 ARM | 7 years | Every 6 months |
10/6 ARM | 10 years | Every 6 months |
These are examples of ARM structures; availability depends on the lender and loan program.
The important thing to remember is that the initial fixed period does not mean the rate is fixed for the entire mortgage term.
Why Do ARMs Have a Lower Initial Rate?
One reason borrowers consider an ARM is that the initial interest rate may be lower than the rate available on a comparable fixed-rate mortgage.
That can result in a lower initial principal-and-interest payment.
However, the initial rate is only one part of the loan.
After the initial fixed period, the interest rate may increase or decrease depending on the loan's index, margin, and applicable caps.
The CFPB recommends looking beyond the initial rate and understanding how high the rate and payment could become after future adjustments.
How Is an ARM Interest Rate Calculated?
Once an ARM enters its adjustment period, the new interest rate is generally based on two components:
Index + Margin = Fully Indexed Interest Rate
The index is a market-based interest rate that can fluctuate over time.
The margin is a fixed percentage determined by the lender and specified in the loan agreement.
For example, if an ARM has:
Index: 4.00%
Margin: 2.00%
The fully indexed rate would be:
4.00% + 2.00% = 6.00%
The actual rate may be subject to the ARM's rate caps and other terms.
The index can change with market conditions, while the margin is established in the loan agreement and generally doesn't change after closing.
What Is the ARM Index?
The index is the market-based benchmark used to help determine the interest rate when your ARM adjusts.
Modern ARMs can be tied to indexes such as SOFR or other permitted benchmarks, depending on the loan program. Freddie Mac, for example, offers SOFR-indexed ARM products.
When the index changes, your ARM's interest rate may change at the next adjustment date, subject to the terms and caps of your loan.
This is one of the biggest differences between an ARM and a fixed-rate mortgage: your future interest rate is connected to market conditions.
What Are ARM Rate Caps?
ARM rate caps are designed to limit how much your interest rate can change.
There are generally three types of caps:
Initial Adjustment Cap
This limits how much the interest rate can increase or decrease when it adjusts for the first time.
Periodic Adjustment Cap
This limits how much the interest rate can change during subsequent adjustment periods.
Lifetime Cap
This limits how much the interest rate can increase over the life of the loan compared with the initial rate.
For example, a loan with a 2/1/5 cap structure could generally allow:
Up to a 2-percentage-point increase at the first adjustment
Up to a 1-percentage-point increase at subsequent adjustments
No more than a 5-percentage-point increase over the initial rate during the life of the loan
The actual terms vary by loan.
Understanding these caps is important because they can tell you how much your interest rate could potentially change.
Can an ARM Interest Rate Go Down?
Yes.
Depending on the loan's terms, an ARM's interest rate can increase or decrease when it adjusts.
If the underlying index falls, your interest rate could decrease at a future adjustment.
However, a decrease is not guaranteed.
Your loan's caps, floor, margin, and other contractual terms can affect how much your rate can move.
That's why borrowers should evaluate an ARM based on both potential increases and potential decreases rather than assuming rates will move in one particular direction.
ARM vs. Fixed-Rate Mortgage
The main difference is how the interest rate behaves over time.
Feature | Fixed-Rate Mortgage | Adjustable-Rate Mortgage |
Initial rate | Fixed | Usually fixed initially |
Rate after initial period | Does not change | Can adjust |
Monthly principal & interest payment | Generally stable | Can increase or decrease |
Exposure to market rate changes | Lower | Higher |
Initial rate | May be higher than an ARM | May be lower than a comparable fixed-rate loan |
Long-term payment certainty | Higher | Lower |
With a fixed-rate mortgage, the principal-and-interest payment generally remains stable for the life of the loan.
With an ARM, the payment can change after the initial fixed period as the interest rate adjusts.
Your total monthly housing payment can still change with a fixed-rate mortgage if property taxes, homeowners insurance, or other escrowed costs change.
What Are the Potential Benefits of an ARM?
An ARM isn't necessarily the right choice for every borrower, but there are situations where its structure may be worth considering.
Potentially Lower Initial Rate
An ARM may offer a lower initial interest rate than a comparable fixed-rate mortgage.
That can mean a lower initial principal-and-interest payment.
Lower Initial Payment
A lower initial rate can create more room in a borrower's initial monthly budget.
However, borrowers should also understand the potential payment after the loan begins adjusting.
More Options for Certain Borrowers
ARMs can provide another option for borrowers who understand the risks of future rate adjustments and have a financial plan that accounts for potential payment changes.
Freddie Mac notes that ARM products may be considered by first-time buyers as well as refinance and move-up borrowers, depending on their circumstances.
What Are the Risks of an ARM?
The biggest consideration is payment uncertainty.
If interest rates increase, your ARM's interest rate may increase when the loan adjusts.
That can increase your monthly principal-and-interest payment.
For example, suppose your initial rate is 5.50%.
If your loan allows the rate to increase by 2 percentage points at the first adjustment, your rate could potentially rise to 7.50% at that adjustment, subject to the loan's specific terms.
A higher rate can result in a significantly higher monthly payment.
That's why the CFPB recommends understanding the maximum possible rate and payment before choosing an ARM.
Don't Assume You'll Sell or Refinance Before the ARM Adjusts
Some borrowers consider an ARM because they expect to sell the property or refinance before the initial fixed period ends.
That may be part of a borrower's financial plan, but it shouldn't be treated as a guarantee.
Home values can change, refinancing conditions can change, and your financial circumstances may be different in the future.
The CFPB specifically cautions borrowers not to assume they will be able to sell or refinance before an ARM's rate changes.
A mortgage should be affordable based on a realistic range of future scenarios—not only on the assumption that you will refinance or move.
Who Might Consider an ARM?
An ARM may be worth discussing with a mortgage professional if you:
Want to explore different interest-rate structures
Expect to own the property for a shorter period
Have a financial plan that accounts for potential rate increases
Prefer a potentially lower initial payment
Understand how the loan's adjustment schedule works
Can afford the payment if the interest rate increases
These factors don't automatically make an ARM the right choice. Your income, debts, credit profile, down payment, financial goals, and loan options should all be considered.
What Should You Ask Before Choosing an ARM?
If you're considering an adjustable-rate mortgage, ask your lender:
1. How long is the initial fixed-rate period?
Know exactly when your first rate adjustment could occur.
2. How often can the rate adjust?
A 5/1 ARM and a 5/6 ARM don't adjust on the same schedule.
3. What index does the loan use?
The index determines an important part of how your future rate is calculated.
4. What is the margin?
The margin is added to the index to determine the fully indexed rate. It can vary between loan offerings.
5. What are the rate caps?
Ask about the initial, periodic, and lifetime caps.
6. What is the highest possible interest rate?
Understanding the maximum rate allowed under your loan terms can help you evaluate the potential risk.
7. What could my monthly payment become?
Ask your lender to show you how your payment could change if interest rates increase.
The CFPB specifically recommends asking about the highest possible payment you may have to make under the loan.
Read the Loan Estimate Carefully
If you apply for an ARM, pay close attention to the information provided in your Loan Estimate and other loan documents.
Look for details about:
Initial interest rate
Initial adjustment period
Future adjustment frequency
Index
Margin
Rate caps
Potential payment changes
Other loan costs
The CFPB recommends reviewing the Loan Estimate and asking questions about anything that differs from what you expected.
Is an ARM Right for You?
There isn't a single mortgage structure that works for every homebuyer.
A fixed-rate mortgage can provide greater payment stability, while an ARM may offer a lower initial rate with the possibility of future
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