Adjustable-Rate Mortgage Guide: Pros, Cons, and Examples

An adjustable-rate mortgage (ARM) is a type of home loan with an interest rate that can change after an initial fixed period. With an ARM, you’ll typically have a lower fixed introductory interest rate (sometimes called a “teaser rate”) for a set period. After this introductory term ends, your interest rate will adjust periodically, usually once a year or every six months.

Adjustable-rate mortgage rates are lower than those of a fixed-rate loan during the initial fixed period. However, when the interest rate begins to adjust, your monthly mortgage payments may change significantly.

The lower initial rate is the main reason this loan is attractive for many borrowers, as it can make it easier to afford a home sooner. However, ARMs are more complicated than fixed-rate mortgages, so it’s important to understand all the ins and outs before deciding whether it’s the right choice for you.

How adjustable-rate mortgages work

To understand an ARM, you need to get to know its structure and the main components.

Initial fixed-rate period

This is the teaser period during which borrowers enjoy a locked-in interest rate and predictable monthly payments.

The length of the period is indicated by the first number in the loan’s name (for example, the “5” in a “5/1 ARM”). It typically lasts three, five, seven, or ten years.

Adjustment period

Once the fixed-rate period ends, your interest rate begins to adjust. This adjustment can occur once per year or once every six months, which is specified by the second number in the ARM’s name (for instance, a 7/6 ARM will adjust every six months).

The index

Your ARM’s interest rate is tied to a specific financial benchmark, or index. When your adjustment period begins, your interest rate goes up or down, depending on the index’s fluctuations.

Some commonly used indices include the Secured Overnight Financing Rate (SOFR) and the Constant Maturity Treasury (CMT).[1][2]

The margin

This is a set percentage that your lender adds to the index to determine your new interest rate. The margin does not change over the life of the loan and is not affected by market conditions.

The fully indexed rate

This is the interest rate after an adjustment. It’s calculated by adding the index to the margin.[3]

ARM caps, explained

There are limits to how much your lender can adjust the interest rate. ARMs have built-in protections called “rate caps” to limit rate increases. There are three main types of caps:

• Initial adjustment cap: Limits how much your interest rate can increase the first time it adjusts after the fixed-rate period ends — usually 2% or 5%.[4]
• Subsequent adjustment cap: Specifies how much your lender can change your rate in any single adjustment period — usually 1% or 2%.
• Lifetime adjustment cap: Limits how much your lender can alter your rate over your entire repayment term — most commonly, 5%.

Although less common, your ARM may also include a payment cap, which specifies how much your monthly mortgage payment can change in one period or over the life of your loan.

ARM loan: A real-world example

Let’s say you have a 5/1 ARM with an initial interest rate of 5%. The margin is 2%, and the rate caps are 2/2/5 (initial/subsequent/lifetime). How would your loan look?

• First five years: Your interest rate stays at 5%.
• First adjustment: Let’s say the index is 5%. Your new rate would be 5% (index) + 2% (margin) = 7%. Since it’s a 2% increase, it falls within the 2% initial adjustment cap.
• Second adjustment: Now, imagine the index has drastically jumped to 8%. Your new rate would be 8% (index) + 2% (margin) = 10%. However, your subsequent adjustment cap is 2%, so your rate can only increase to 9% from the previous 7%.

ARMs: Common types, explained

There are three main types of adjustable-rate mortgages borrowers can encounter.

Hybrid ARMs

This is the most popular type of ARM. As the name suggests, they offer a combination of fixed-rate and adjustable-rate periods.

Your hybrid ARM would begin with a fixed-rate period for a certain number of years. Then it transitions to an adjustable-rate period for the remainder of your loan term, which typically lasts 30 years in total. The name of the loan tells you about its structure:

• 5/1 or 5/6 ARM is fixed for the first five years and then adjusts annually or semi-annually.
• 7/1 or 7/6 ARM is fixed for the first seven years and then adjusts annually or semi-annually.
• 10/1 or 10/6 ARM is fixed for the first ten years and then the rate adjusts annually or semi-annually.

Generally, the shorter the introductory period, the lower the initial interest rate you can be offered. For example, a 3/1 ARM will likely have a lower introductory rate than a 10/1 ARM.

Interest-only ARM

An interest-only ARM lets you pay only interest for the first few years of your loan. Once that period ends, you’ll start paying both principal and interest each month. As a result, you can benefit from very low initial payments, but it also prevents you from building equity.

It’s also worth noting that once the interest-only period ends, your monthly payments are likely to increase significantly.

Payment-option ARM

With a payment-option ARM (also called an option ARM), you can choose between different payment options every month, with the main ones being:

• A traditional principal and interest payment
• An interest-only payment
• A minimum payment, which may be lower than an interest-only payment

While payment-option ARMs offer flexibility, they can also be risky, as the minimum payment option may not cover all of the interest. This could lead to a negative amortization, increasing the amount you owe.

Now rare, payment option ARMs were much more common before the 2008 financial crisis. They were also one of the contributors to the crisis.

Pros and cons of ARMs

Like any other mortgage type, ARMs have their advantages and disadvantages. Borrowers choosing an adjustable-rate mortgage should weigh them carefully before deciding whether it’s the right move for them.

Pros

✅ Lower initial interest rates: This is the biggest draw of ARM loans. Lower initial payments can free up cash for other expenses, such as renovations. Alternatively, you may expect to earn more when the fixed-rate period ends, so increased interest rates later would not be a burden.

✅ More buying power: Since the initial payment is lower, you may be able to qualify for a larger loan than you would with a fixed-rate mortgage. This allows you to buy a more expensive house.

✅ Good for short-term homeowners: ARMs may be a good choice for those planning to sell or refinance before the fixed-rate period ends—for example, investors, or those planning to move within a few years.

✅ Potential for future lower rates: ARM loans are a gamble, which may pay off—if interest rates go down, your monthly payments could decrease after the adjustment period.

Cons

❌ Lack of predictability: There’s the possibility that monthly payments could increase significantly when the ARM first adjusts. This could result in much higher expenses and may not be the best choice for risk-averse homeowners.

❌ Harder to budget: The unpredictable nature of ARMs also makes it much harder to plan your finances long-term compared to a stable fixed-rate mortgage.

❌ Refinancing not guaranteed: You may not be able to refinance into a better loan when the time comes, potentially locking you into a higher rate.

Fixed-rate vs. adjustable-rate mortgages

Choosing between ARMs and their fixed-rate counterparts is one of the most critical decisions for aspiring homebuyers. The right answer in the fixed vs. adjustable rate mortgage debate depends on your financial situation, future plans, and risk tolerance.

When an ARM makes sense

How do you know if it is a good idea to get an adjustable-rate mortgage in your situation? Here are some examples of situations where an ARM could be a good fit:

• You plan to sell your home before the fixed-rate period ends.
• You expect your income to increase significantly in the future.
• You expect that rates may go down in a few years and are comfortable with risk.
• You want to take advantage of a lower initial payment to invest or build your savings.

However, you may want to think twice about whether an ARM is the right option for you if:

• You plan to stay in your home for a longer term.
• You prefer predictable, stable monthly payments.
• You are risk-averse and want to avoid the possibility of your payments increasing.

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