• An adjustable-rate mortgage (ARM) is a home loan with an interest rate that adjusts at predetermined intervals based on market conditions.
  • Compared to fixed-rate mortgages, in which the rate does not change over the term of the loan, ARMs typically offer lower introductory rates.
  • ARMs may work well for buyers who are confident they can manage any mortgage payment increases resulting from fluctuating interest rates, as well as buyers who plan to sell before the introductory period ends.

When you’re buying a home, choosing the right mortgage financing is crucial. Your financing determines how much of a down payment is required, how much your mortgage payment may be, and how much you pay in interest expense over the life of the loan.

Pursuing financing with an interest rate that varies over time, called an ARM, could potentially save money in the short term by providing a lower starting rate.[1] However, there is a risk that the rate could increase over time, ultimately costing more over the life of the loan.

This article will explain what adjustable-rate mortgages are and how they work. You’ll also explore the pros and cons so you can decide if an adjustable-rate mortgage is right for you.

What Is an Adjustable-Rate Mortgage?

An adjustable-rate mortgage is a home loan in which the interest rate periodically changes with market conditions (after an introductory flat-rate period).

ARMs are characterized by:[1] 

  • An introductory period (typically of 3, 5, 7, or 10 years) during which the interest rate is set at a favorable rate, typically below the rates offered for a fixed-rate mortgage.
  • Automatic rate adjustments at predetermined intervals, after the introductory period, that are based on changes in a market index, such as the U.S. prime rate or the Constant Maturity Treasury (CMT) rate, with caps in place to prevent excessive changes.
  • Changing mortgage payment amounts that reflect the changes in interest rates after the introductory period.

If interest rate indexes decline in the future, your interest rate automatically adjusts to reflect the lower rates, which could result in a lower mortgage payment (depending on other variables like insurance premiums and property taxes). However, if indexes increase, your interest rate automatically increases, resulting in a higher mortgage payment.

It is important to understand how high your mortgage payments could potentially increase and be financially comfortable with that maximum figure before accepting an ARM. 

Adjustable-Rate Mortgages vs Fixed-Rate Mortgages

With ARMs, the interest rate automatically fluctuates to account for changing economic conditions. With a fixed-rate mortgage, on the other hand, you lock in today’s rate for the term of the loan. 

A fixed-rate mortgage allows you to keep your initial rate until you sell the home, pay off the mortgage, or refinance the home loan. A refinance (refi) is when you replace your existing mortgage with a new mortgage under new terms. So, if interest rates decline in the future, you may want to refinance to lock in the new, lower rate. However, you would need to qualify for refinancing and consider the cost of refinancing to determine if that is the right course of action at that point.

How Does an Adjustable-Rate Mortgage Work?

Adjustable-rate mortgages consist of two phases:[1]

  1. The fixed introductory period, during which your interest rate does not change.
  2. The adjustable period, during which your rate changes at set intervals.

These phases are reflected in the mortgage product names, with the first number indicating the length of the introductory period and the second number indicating the interval at which the interest rate changes after the introductory period. Consider the following examples:

  • With a 5/1 ARM, the introductory period is 5 years, and the rate fluctuates once per year after the intro period.
  • With a 3/6 ARM, the introductory period is 3 years, and the rate fluctuates every six months after the intro period (not every six years, as one might think).
  • With a 7/1M ARM, the introductory period is 7 years, and the rate fluctuates every month after the intro period (as designated by the M, although no M is used when the rate fluctuates every six months in the example above due to longstanding industry standards).

How New Interest Rates are Calculated in an ARM

At each fluctuation point, the new interest rate in an ARM is calculated based on the index plus a margin, both of which are established when the loan is originated.[1]

Interest Rate = Index + Margin

The index can be any financial index used by your chosen lender. As mentioned above, the U.S. prime rate and the Constant Maturity Treasury (CMT) rate are commonly used indexes.

The margin is the percentage points above the baseline index to ensure that the loan is financially feasible for the lender.

The total of the index plus the margin is the new interest rate, also called the fully-indexed interest rate.

Importantly, the new interest rate is subject to limits, as established at the time of the loan origination.[2] A loan might, for example, come with a 2% fluctuation limit, which means that the loan cannot increase or decrease by more than 2% from one period to the next.

It is common to see ARM limits expressed as 3-digit numbers to indicate the initial adjustment cap, the subsequent adjustment cap, and the lifetime adjustment cap. For example, a 2-2-5 ARM has a 2% adjustment cap for the initial adjustment, a 2% cap on subsequent adjustments, and a 5% lifetime adjustment cap.

Can You Refinance an Adjustable-Rate Mortgage?

ARMs can be refinanced as long as the borrower qualifies and the cost of the refi is worth it. Refinancing ARMs to fixed-rate mortgages is common when homeowners expect rates to increase for the foreseeable future. During periods of higher-than-normal interest rates, some borrowers strategically take an ARM, sometimes with purposefully longer introductory rates like seven years, with the hope of refinancing to lower rates before the introductory period ends.

However, you should not go into an ARM with the assumption that you will be able to refinance before rates increase. Your financial situation could change, or your property could temporarily decline in value, which could prohibit you from qualifying for a refi. Furthermore, rates might not decrease in the future, so it is possible to miss out on today's rates while waiting for better rates that never materialize.

Pros and Cons of Adjustable Rate Mortgages

Advantages of Adjustable-Rate Mortgages 

The benefits of ARMs include:

  • Lower initial interest rates. ARMs typically start with lower mortgage rates than fixed-rate loans, which can mean lower monthly payments during the introductory period. 
  • Greater buying power. With a lower rate, you may be able to afford a higher-priced home by allocating more of your short-term budget to paying the principal loan balance. However, you must be able to afford the mortgage payments if interest rates rise, so this is not an invitation to purchase a home above your means.    
  • Potential savings. If interest rates decline in the future (after your introductory period expires), your rate may adjust down, reducing your mortgage payment and saving you money, which could be used to achieve other financial goals. Because this adjustment occurs automatically, you don’t have to apply for or pay for a refinance to get the lower rate.
  • Caps offer some protection against sudden, extreme increases. While your interest rate fluctuates periodically, it cannot exceed the cap listed in your loan agreement.

Potential Drawbacks of Adjustable-Rate Mortgages

The possible downsides of ARMs include:

  • Possible rate increases. If interest rates increase after your introductory period expires, your mortgage rate and mortgage payments increase. Homeowners who are unable to afford the higher payments may face foreclosure.
  • Uncertainty. There is no way to know at closing what your future interest rates or mortgage payments will be, so household budgeting may be more difficult. Additionally, you cannot know upfront how much you may end up paying in interest over the term of the loan.
  • Greater complexity. ARMs have adjustment periods, margins, caps, and indexes that can be confusing for some borrowers.

Is an Adjustable Rate Mortgage Right for You?

An ARM may be a sound option for you if:

  • You are a homebuyer who plans to sell the home before the end of the introductory period (perhaps you're buying a starter home and plan to upgrade within 5-7 years).
  •  You can reasonably expect your income to grow significantly over time (medical residents, for example, can expect to earn more once they can practice independently).
  •  You are a real estate investor who purchases fixer-uppers to renovate and resell quickly. 

However, an arm may not be the right fit for you if:

  • You plan to remain in the home for longer than the introductory period.
  • You prefer the predictability of fixed interest rates and stable monthly payments.
  • You are unsure about your ability to cover the mortgage payment if rates increase to their maximum limit.

How to Apply for an Adjustable-Rate Mortgage

The process of applying for a mortgage begins with a pre-approval. Pre-approval is when a lender reviews your finances to determine if you qualify for a home loan and, if so, how much you can borrow. This helps you determine a reasonable homebuying budget so you can focus on the right price range from the beginning of your house hunt. Just as importantly, being pre-approved may increase your chances of getting an offer accepted by showing the seller that you are a serious, qualified buyer. 

Learn more about the pre-approval process and begin your application today!