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

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.

An ARM may be worth considering if you expect to move or refinance before the fixed period ends, though neither is guaranteed.

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.

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:

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.

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.

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.

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

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 rise, 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.

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.

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, make sure you understand how your rate and payment could change at each adjustment.

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.

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.

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.

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.

Federal rules generally prohibit prepayment penalties on adjustable-rate mortgages. Your Loan Estimate shows whether any loan you're offered has a prepayment penalty.

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.

Every 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.

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.