Adjustable Rate Mortgage: How an ARM Works, Who It’s For

What's an adjustable-rate mortgage?

An adjustable-rate mortgage has an interest rate that changes periodically with the broader market.

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 changes regularly, based on a benchmark index.

If the index is lower than when you got the loan, your interest rate and mortgage payment will decrease. But if it's higher, your interest 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.

» MORE: Find adjustable-rate mortgage lenders

ARMs vs. fixed-rate mortgages

The main difference between ARMs and fixed-rate mortgages is that ARMs have an interest rate and monthly payments that can go up and down over time, whereas fixed-rate mortgages have an interest rate that never changes, so the monthly principal-and-interest payments stay the same.

ARMs gain popularity when their introductory interest rates are lower than those for fixed-rate mortgages. The resulting smaller monthly payments give borrowers more homebuying power. But the rate and monthly payment on an ARM have the potential to rise, which could make the payments difficult to afford. Borrower beware.

» MORE: ARMs vs. fixed-rate mortgages: How to compare

Is an ARM a good idea?

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 starts.

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 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.

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

» MORE: Adjustable-rate mortgages: the pros and cons

Types of adjustable-rate mortgages

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

Most new ARMs use a benchmark index called the secured overnight financing rate (SOFR). ARMs based on this index adjust 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 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.

How ARM rates are set

To understand how ARM rates are adjusted, you need to know a few terms.

ARM caps

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

• Initial adjustment cap: The maximum amount the rate can increase the first time it is adjusted.

• Subsequent adjustment cap: The maximum amount the rate can increase at each adjustment thereafter.

• Lifetime adjustment cap: The maximum amount the rate can go up during the loan term, or the number of years it will take to pay off the mortgage.

For example, a 5-year ARM typically has:

• An initial adjustment cap of 2 percentage points.

• A subsequent adjustment cap of 1 percentage point.

• A lifetime adjustment cap of 5 percentage points.

Let's say the introductory rate was 5%:

• The interest rate could go as high as 7% after the first adjustment at the 61st month: the introductory rate of 5% plus the 2% initial adjustment cap.

• The rate could go as high as 8% at the second adjustment six months later: that 7% rate plus the 1% subsequent adjustment cap.

• Eventually, the rate could reach a maximum of 10%: the initial 5% rate plus the 5% lifetime adjustment cap. This describes a worst-case scenario, which wouldn't necessarily happen.

When rates adjust, they don't always go up. They can go down in the initial or subsequent adjustments. And they don't necessarily go up or down the maximum amount. For example, the rate could rise or fall 1 percentage point in the initial adjustment instead of the maximum 2 percentage points.

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 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. Life has a way of disrupting plans.

More ARM terms to know

Here are terms to know when comparing ARMs.

• Index rate: The benchmark rate lenders use for ARMs. The index rate changes over time.

• Margin: A number of percentage points that your lender adds to the index rate to arrive at the interest rate that you pay during each adjustment period. The margin doesn't change.

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

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

You can refinance an ARM

Regardless of which type of loan you have, you may refinance your mortgage to take advantage of lower interest rates. As a homeowner with an ARM, you may refinance into a fixed-rate mortgage if you want to switch to a loan with an unchanging interest rate.