Adjustable-Rate Mortgage: What an ARM Is and How It Works
When fixed-rate mortgage rates are high, lenders may start to recommend adjustable-rate mortgages (ARMs) as monthly-payment saving alternatives. Homebuyers typically choose ARMs to save money temporarily since the initial rates are usually lower than the rates on current fixed-rate mortgages.
Because ARM rates can potentially increase over time, it often only makes sense to get an ARM loan if you need a short-term way to free up monthly cash flow and you understand the pros and cons.
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What is an adjustable-rate mortgage?
An adjustable-rate mortgage is a home loan with an interest rate that changes during the loan term. Most ARMs feature low initial or “teaser” ARM rates that are fixed for a set period of time lasting three, five or seven years.
Once the initial teaser-rate period ends, the adjustable-rate period begins. The ARM rate can rise, fall or stay the same during the adjustable-rate period depending on two things:
- The index, which is a banking benchmark that varies with the health of the U.S. economy
- The margin, which is a set number added to the index that determines what the rate will be during an adjustment period
How does an ARM loan work?
There are several moving parts to an adjustable-rate mortgage, which make calculating what your ARM rate will be down the road a little tricky. The table below explains how it all works.
ARM adjustments in action
The best way to get an idea of how an ARM can adjust is to follow the life of an ARM. For this example, we assume you’ll take out a 5/1 ARM with 2/2/6 caps and a margin of 2%, and it’s tied to the Secured Overnight Financing Rate (SOFR) index, with an 5% initial rate. The monthly payment amounts are based on a $350,000 loan amount.
Breaking down how your interest rate will adjust:
- Your rate and payment won’t change for the first five years.
- Your rate and payment will go up after the initial fixed-rate period ends.
- The first rate adjustment cap keeps your rate from going above 7%.
- The subsequent adjustment cap means your rate can’t rise above 9% in the seventh year of the ARM loan.
- The lifetime cap means your mortgage rate can’t go above 11% for the life of the loan.
ARM caps in action
The caps on your adjustable-rate mortgage are the first line of defense against massive increases in your monthly payment during the adjustment period. They come in handy, especially when rates rise rapidly — as they have the past year. The graphic below shows how rate caps would prevent your rate from doubling if your 3.5% start rate was ready to adjust in June 2023 on a $350,000 loan amount.
*The 30-day average SOFR index shot up from a fraction of a percent to more than 5% for the 30-day average from June 1, 2022, to June 1, 2023. The SOFR is the recommended index for mortgage ARMs. You can track SOFR changes here.
What it all means:
- Because of a big spike in the index, your rate would’ve jumped to 7.05%, but the adjustment cap limited your rate increase to 5.5%.
- The adjustment cap saved you $353.06 per month.
Things you should know
Lenders that offer ARMs must provide you with the Consumer Handbook on Adjustable-Rate Mortgages (CHARM) booklet, which is a 13-page document created by the Consumer Financial Protection Bureau (CFPB) to help you understand this loan type.
What all those numbers in your ARM disclosures mean
It can be confusing to understand the different numbers detailed in your ARM paperwork. To make it a little easier, we’ve laid out an example that explains what each number means and how it could affect your rate, assuming you’re offered a 5/1 ARM with 2/2/5 caps at a 5% initial rate.
Types of ARMs
Hybrid ARM loans
As mentioned above, a hybrid ARM is a mortgage that starts out with a fixed rate and converts to an adjustable-rate mortgage for the remainder of the loan term.
The most common initial fixed-rate periods are three, five, seven and 10 years. You’ll see these loans advertised as 3/1, 5/1, 7/1 or 10/1 ARMs. Occasionally the adjustment period is only six months, which means after the initial rate ends, your rate could change every six months.
Always read the adjustable-rate loan disclosures that come with the ARM program you’re offered to make sure you understand how much and how often your rate could adjust.
Interest-only ARM loans
Some ARM loans come with an interest-only option, allowing you to pay only the interest due on the loan each month for a set time ranging between three and 10 years. One caveat: Although your payment is very low because you aren’t paying anything toward your loan balance, your balance remains the same.
Payment option ARM loans
Before the 2008 housing crash, lenders offered payment option ARMs, giving borrowers several options for how they pay their loans. The choices included a principal and interest payment, an interest-only payment or a minimum or “limited” payment.
The “limited” payment allowed you to pay less than the interest due each month — which meant the unpaid interest was added to the loan balance. When housing values took a nosedive, many homeowners ended up underwater — with loan balances higher than the value of their homes. The foreclosure wave that followed prompted the federal government to heavily restrict this type of ARM, and it’s rare to find one today.
How to qualify for an adjustable-rate mortgage
Although ARM loans and fixed-rate loans have the same basic qualifying guidelines, conventional adjustable-rate mortgages have stricter credit standards than conventional fixed-rate mortgages. We’ve highlighted this and some of the other differences you should be aware of:
You’ll need a higher down payment for a conventional ARM. ARM loan guidelines require a 5% minimum down payment, compared to the 3% minimum for fixed-rate conventional loans.
You’ll need a higher credit score for conventional ARMs. You may need a score of 640 for a conventional ARM, compared to 620 for fixed-rate loans.
You may need to qualify at the worst-case rate. To make sure you can repay the loan, some ARM programs require that you qualify at the maximum possible interest rate based on the terms of your ARM loan.
You’ll have extra payment adjustment protection with a VA ARM. Eligible military borrowers have extra protection in the form of a cap on yearly rate increases of 1 percentage point for any VA ARM product that adjusts in less than five years.
Pros and cons of an ARM loan
Should you get an adjustable-rate mortgage?
An adjustable-rate mortgage makes sense if you have time-sensitive goals that include selling your home or refinancing your mortgage before the initial rate period ends. You may also want to consider applying the extra savings to your principal to build equity faster, with the idea that you’ll net more when you sell your home.