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 term of the loan. It may also be called a “hybrid mortgage” because it combines the features of a fixed-rate and an adjustable-rate mortgage into one loan.
ARM rates usually start out low for a set time of three, five or seven years. Once the adjustment period ends, the rate can rise, fall or stay the same depending on a number of factors. ARM loans are available for conventional loans and mortgages backed by the Federal Housing Administration (FHA) or the U.S. Department of Veterans Affairs (VA).
Standard features of ARM loans typically include:
- A lower starting rate than what’s available for 30-year fixed-rate mortgages
- A cap on how much the rate can increase yearly after the initial rate period ends
- A lifetime limit on how much the rate can rise
How does an ARM loan work?
There are six major parts of an ARM loan that affect how much and how often your rate could change over time. 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 them.
The ARM components are divided into two categories: the ones that move and the ones that are fixed throughout the loan’s life.
| ARM components that move | ARM components that are fixed |
|---|---|
| ⇈⮇ Initial rate This is the start or “teaser” rate that’s typically fixed for three, five, seven or 10 years. After the teaser period ends, the rate can change. | Margin The margin is a fixed number of percentage points added to your index to calculate your interest rate during the adjustment period. |
| ⇈⮇ Index The index is a benchmark interest rate that changes based on what’s happening in financial markets. Many ARM programs use the COFI or CMT index. | First payment adjustment cap This is the maximum number of percentage points your rate can go up after your initial rate period ends and is set based on the ARM program you choose. |
| Subsequent adjustment period This is a set number of years or months between each adjustment. | |
| Lifetime cap This number tells you the maximum your rate can rise from where it started. |
How variable rates on ARM loans are determined
There are a lot of numbers to understand when it comes to calculating how much and how often your ARM rate could change, so we’ve laid out an example for you to show you how an ARM works.
Let’s assume you’re offered a 5/1 ARM with 2/2/5 caps and a start rate of 5%.
| What the numbers mean | How the numbers affect your ARM rate |
|---|---|
| The 5 in the 5/1 ARM means your rate is fixed for the first 5 years | Your rate is fixed at 5% for the first 5 years |
| The 1 in the 5/1 ARM means your rate will adjust every year after the 5-year fixed-rate period ends | ⛭ After your 5 years, your rate can change every year |
| The first 2 in the 2/2/5 adjustment caps means your rate could go up by a maximum of 2 percentage points for the first adjustment | ⛭ Your rate could increase to 7% in the first year after your initial rate period ends |
| The second 2 in the 2/2/5 caps means your rate can only go up 2 percentage points per year after each subsequent adjustment | ⛭ Your rate could increase to 9% in the second year and 10% in the third year after your initial rate period ends |
| The 5 in the 2/2/5 caps means your rate can go up by a maximum of 5 percentage points above the start rate for the life of the loan | Your rate can’t go above 10% for the life of your loan |
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
| Pros | Cons |
|---|---|
Lower initial rate (usually) compared to comparable fixed-rate mortgages | Rate could adjust and become unaffordable |
Lower payment for temporary savings needs | Higher down payment may be required |
Good choice for borrowers to save cash if they plan to sell their home and move soon | May require higher minimum credit scores |
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.
Frequently asked questions
Yes, you can refinance your ARM to a fixed-rate loan as long as you qualify for the new mortgage.
An ARM doesn’t make sense if you’re buying or refinancing your “forever home” or if you can only afford the teaser rate.
Yes, if your ARM loan comes with a “conversion option.” Lenders may offer this choice with conditions and potentially an extra cost, allowing you to convert your ARM loan to a fixed-rate loan.