Adjustable-Rate Mortgage (ARM): Everything you need to know

An adjustable-rate mortgage (ARM) can be an attractive option for homebuyers looking for lower initial interest rates.

However, since an ARM’s interest rate fluctuates over time, this type of loan can be riskier than a fixed-rate mortgage.

Understanding how an ARM works, its pros and cons, and the different types available will help you decide whether it’s the right mortgage option for you.

In this article, we will cover the key aspects of adjustable-rate mortgages, including how they work, how their rates are determined, and whether they are a good choice for your financial situation.

What is an Adjustable-Rate Mortgage?

An adjustable-rate mortgage (ARM) is a type of home loan with an interest rate that changes periodically based on market conditions.

Unlike a fixed-rate mortgage, which maintains the same interest rate throughout the loan term, an ARM starts with a fixed-rate period before transitioning to a variable rate.

This means your monthly payments may increase or decrease over time, depending on market fluctuations.

While ARMs can offer lower initial interest rates than fixed-rate mortgages, they also come with the risk of rising payments in the future.

How does an Adjustable-Rate Mortgage work?

An ARM has two phases:

• Fixed-Rate Period – The interest rate remains constant for an initial period, which can range from a few months to several years (e.g., 3, 5, 7, or 10 years).
• Adjustable-Rate Period – After the fixed-rate period ends, the interest rate is adjusted at regular intervals (usually annually or semiannually) based on a reference index plus a margin set by the lender.

For example, in a 5/1 ARM, the interest rate is fixed for the first five years, then adjusts every year after that.

The adjustment is based on a financial index (such as the U.S. Treasury rate) plus a defined margin.

Adjustable-Rate Mortgage vs. Fixed-Rate Mortgage

When choosing between an ARM and a fixed-rate mortgage, it’s important to understand the differences:

While an ARM can be a smart choice for homebuyers planning to sell or refinance before the rate adjustment, a fixed-rate mortgage offers more predictability and stability.

Types of Adjustable-Rate Mortgages

There are several types of adjustable-rate mortgages, each with its unique structure.

Hybrid ARM

A hybrid ARM starts with a fixed interest rate for a specific period before transitioning to an adjustable-rate loan. Common options include:

• 3/1 ARM – Fixed for 3 years, then adjusts annually.
• 5/1 ARM – Fixed for 5 years, then adjusts annually.
• 7/1 ARM – Fixed for 7 years, then adjusts annually.
• 10/1 ARM – Fixed for 10 years, then adjusts annually.

The longer the fixed period, the more stable your payments will be in the early years of the loan.

Interest-Only ARM

An interest-only (IO) ARM allows borrowers to pay only the interest for a set period (usually 3 to 10 years).

After that, payments increase to cover both the principal and interest, often leading to significantly higher monthly payments.

Payment-Option ARM

A payment-option ARM gives borrowers flexibility to choose from different types of payments each month:

• Minimum payment – The lowest possible payment, which may not cover all interest costs (leading to negative amortization).
• Interest-only payment – Covers interest but does not reduce the loan principal.
• Fully amortizing payment – Covers both principal and interest, ensuring the loan is paid off over time.

While payment-option ARMs offer flexibility, they can also be risky, as negative amortization may cause the loan balance to increase over time.

How is the Adjustable Rate in an ARM determined?

When an ARM’s fixed period ends, the interest rate adjusts based on two factors:

• Index – A benchmark interest rate reflecting market conditions. Common indices include:
  • Secured Overnight Financing Rate (SOFR) – A replacement for LIBOR.
  • Constant Maturity Treasury (CMT) – Based on U.S. Treasury yields.
  • Cost of Funds Index (COFI) – Based on bank borrowing costs.
• Margin – A fixed percentage added to the index, set by the lender when you take out the loan.

For example, if the index rate is 2% and the margin is 2.5%, the new interest rate would be 4.5%.

Lenders also set rate caps, which limit how much the rate can increase in each adjustment period and over the life of the loan.

Is an Adjustable-Rate Mortgage a good choice?

Choosing an ARM depends on your financial goals and risk tolerance. Let’s explore the pros and cons.

Advantages of an ARM

• Lower Initial Rates – ARMs typically offer lower initial interest rates than fixed-rate mortgages, resulting in lower initial payments.
• Potential for Lower Payments – If market rates decrease, your ARM’s rate and monthly payments may also go down.
• Good for Short-Term Homeownership – If you plan to move or refinance before the adjustable period begins, you can benefit from the lower initial rate without worrying about future adjustments.

Disadvantages of an ARM

• Uncertain Payments – Once the fixed period ends, your monthly payments may fluctuate, making budgeting harder.
• Rate Increase Risk – If interest rates rise, your mortgage payments may increase significantly, leading to financial strain.
• Complex Terms – ARMs often include rate caps, floors, and negative amortization, making them more complicated than fixed-rate loans.

Who should consider an ARM?

• Buyers who plan to sell or refinance before the adjustable period begins.
• Borrowers comfortable with market fluctuations and potential payment increases.
• Investors or individuals seeking lower initial payments for a short-term financial advantage.

An adjustable-rate mortgage (ARM) can be a smart option for borrowers looking for lower initial payments and flexibility, but it comes with risks related to rising interest rates and payment uncertainty.

Before choosing an ARM, carefully evaluate your financial goals, homeownership timeline, and risk tolerance.

Consulting a mortgage professional can help you determine whether an ARM or a fixed-rate mortgage is the best choice for your situation.

For more financial insights, stay connected and explore more articles on our website! Want a suggestion? Also, check out our guide on how a fixed-rate mortgage works!