What Is an Adjustable-Rate Mortgage?

Adjustable-rate mortgages, or ARMs, have interest rates that can change over time. ARMs are best if you plan to move or pay off the loan before the introductory rate expires.
Jun 24, 2022

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Adjustable-rate mortgages are gaining popularity because their relatively low introductory rates can give borrowers more homebuying power amid today's soaring home prices.

If you plan to relocate or pay off your mortgage in 10 years or less, an adjustable-rate mortgage, or ARM, is worth considering.

But ARMs aren't right for everyone. Unlike fixed-rate mortgages, which have an interest rate that stays the same through the life of the loan, ARMs have variable rates. Make sure you understand how these mortgages work before applying for one.

Adjustable-rate mortgage definition

An adjustable-rate mortgage is a home loan with an interest rate that can change periodically. An ARM starts with a low fixed rate during the introductory period, which typically is three, five, seven or 10 years. When the introductory period expires, the interest rate you pay adjusts at predetermined intervals according to a benchmark index.

If the index is lower than when you got the loan, your rate and mortgage payment will decrease. But if it's higher, your rate and mortgage payment will go up. ARM rates continue to change periodically after the introductory period — usually once every six months — until you sell the home, refinance, or pay back the mortgage in full. ARMs usually have 30-year terms.

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Types of adjustable-rate mortgages

A variety of ARMs are available. Hybrid ARMs are the most common, but some lenders offer interest-only ARMs. Payment-option ARMs are rare.

Hybrid ARMs

These mortgages have two phases: a fixed-rate period — typically three, five, seven or 10 years — followed by an adjustable phase in which your interest rate can move up or down, depending on an index.

Most new ARMs use a benchmark index called the Secured Overnight Financing Rate, or SOFR. ARMs based on this index adjust once every six months after the introductory period.

So a 5-year ARM with a 30-year term has a fixed interest rate for the first five years and a rate that adjusts every six months for the next 25 years. You also might also see 5-year ARMs called 5/6 or 5y/6m ARMs.

The naming of ARMs is slightly different than in previous years when most ARMS were based on the Libor, or London Interbank Offered Rate. Libor-based ARMs had rates that adjusted once a year after the introductory period. Instead of a 5/6 ARM, the shorthand for a 5-year ARM was 5/1.

Some possible hybrid ARMs:

  • 3-year ARM, or 3/6 ARM: The interest rate is fixed for three years, and then adjusts every six months.

  • 5-year ARM, or 5/6 ARM: The interest rate is fixed for five years, and then adjusts every six months.

  • 7-year ARM, or 7/6 ARM: The interest rate is fixed for seven years, and then adjusts every six months.

  • 10-year ARM, or 10/6 ARM: The interest rate is fixed for 10 years, and then adjusts every six months.

The initial interest rate tends to be lower with a shorter fixed-rate period. So generally you'll see lower introductory rates for a 3-year ARM than for a 10-year ARM.

Interest-only ARMs

An interest-only, or IO, ARM gives you a specified number of years, typically between three and 10, during which you pay only interest on your mortgage. Your payments stay low during the fixed-rate interest-only period. But paying only interest doesn’t reduce the loan amount. When the introductory period ends your payments will be much bigger, because they’ll include both principal and interest. Not all lenders offer interest-only ARMs.

Payment-option ARMs

These ARMs became rare after the 2008 Great Recession when millions of homeowners defaulted on their mortgages and lost their homes. Payment-option ARMs allow borrowers to choose among a few monthly payment options: an interest-only payment, a minimum payment that does not pay all the interest due, or a fully amortizing payment that includes principal and interest. These complex loans are risky because payments can go way up after the introductory period, and a borrower who makes only minimum payments could end up owing more than the original mortgage.

How an adjustable-rate mortgage works

Shopping for an adjustable-rate mortgage requires more than just looking at the introductory interest rate. Here are some of the basic things you'll want to understand.

ARM caps

Adjustable-rate mortgages have caps on how much the interest rate can go up. They include:

  • First adjusted interest rate cap: The maximum amount the rate can increase when it's adjusted for the first time.

  • Subsequent adjusted interest rate cap: The maximum amount the rate can increase at each adjustment after the first time.

  • Lifetime rate cap: The maximum amount the rate can go up during the loan term.

When considering an ARM, check the caps and calculate how much your monthly mortgage payment could increase. Would you be able to afford the mortgage payment if the interest rate rose up to the cap? That's a good question to ask, even if you think you'll move and sell the home before the introductory period ends.

Other ARM terms

Here are other terms to know when comparing ARMs.

  • Index rate: The variable benchmark rate lenders use for ARMs.

  • Margin: A constant rate that is added to the index rate. The sum of the margin and index rate equals the rate you pay.

  • Introductory or teaser rate: The interest rate you pay during the loan's fixed-rate period.

  • Adjustment frequency: How often the rate adjusts after the introductory fixed-rate period.

When an adjustable-rate mortgage makes sense

Here are some scenarios when an ARM might be a good choice.

  1. You're not buying a forever home. If you move in several years, an ARM could save you money. You'd benefit from the low introductory fixed rate, then sell the home before the adjustable period started.

  2. You plan to pay off the mortgage quickly. Say, for instance, you expect a financial windfall, such as an inheritance. With an ARM, you would save money with the low introductory fixed rate, and then pay off the balance altogether with the windfall. Ideally the money would come in before the fixed-rate period ended.

  3. You want initial low payments and are comfortable with the risk of higher payments later. There's also the possibility of the benchmark index dropping, which would mean your rate would decrease after the fixed period. But don't count on it. No one can accurately predict where interest rates will be years from now.

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When to choose a fixed-rate mortgage instead

If you plan to set down roots and own the home for the long haul, or if you'll rest easier with a constant mortgage rate and monthly payment, then a fixed-rate mortgage is probably the better choice.

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