An adjustable-rate mortgage (ARM) is a home loan with an interest rate that stays fixed for an introductory period and then can adjust over time based on the terms of the loan. Borrowers often consider an ARM when they want a lower initial payment, expect to move or refinance before the first adjustment, or are comfortable taking on some future rate uncertainty in exchange for a lower starting rate.
This article explains how an ARM works, including the introductory fixed-rate period, how later rate changes are calculated, what rate caps mean, and when an ARM may make sense compared with a fixed-rate mortgage.
An adjustable-rate mortgage is a home loan that begins with a fixed interest rate for a set introductory period and then adjusts according to the terms in your loan documents. After that intro period ends, the new rate is generally based on an index plus a margin.
The index is a market-based benchmark, and the margin is the number of percentage points the lender adds to that index to determine your new interest rate. ARM products also state how often the rate can change after the first adjustment, such as every six months or every year, depending on the loan.
Because ARM terms vary by lender and program, borrowers should review the disclosures for the loan they are considering. Those disclosures explain the loan’s features, including how the rate can adjust, when changes can happen, and other key terms.
ARMs are structured around a few core features that borrowers should understand before choosing one. First, the loan has an introductory fixed-rate period. During that time, your interest rate and principal-and-interest payment do not change.
After the introductory period ends, the loan moves into its adjustment phase. The loan terms will state the index used, the lender’s margin, how often the rate may change, and any limits on how much the rate can increase or decrease at each adjustment and over the life of the loan.
Just as importantly, ARM terms are disclosed up front. Borrowers should review how the adjustment schedule works, what triggers payment changes, and how much their payment could rise after the fixed period ends.
Rate caps limit how much an ARM’s interest rate can change. While exact terms vary by loan, borrowers will commonly see three types of caps: an initial adjustment cap, a periodic cap, and a lifetime cap.
The initial adjustment cap limits how much the rate can change the first time the loan resets after the introductory period. The periodic cap limits how much the rate can change at each later adjustment. The lifetime cap limits how much the rate can increase over the full life of the loan.
These caps matter because once the rate begins to adjust, the changes to your interest rate and payment are based on the market, not your personal financial situation. Caps can help limit the speed and size of payment increases, but they do not prevent the payment from rising. Before choosing an ARM, make sure you understand how much your monthly payment could change if rates move higher.
The primary advantages of an ARM begin with the borrower having access to a mortgage where the applicable interest rates are usually lower that those charged on fixed-rate loans, which helps keep the monthly payments lower over the first couple years of the loan.
This is particularly valuable to marginal borrowers who may need lower payments in order to qualify for a home loan. Also, many ARMs allow for principal prepayments without being charged a prepayment penalty.
The biggest issue related to an ARM is the unpredictability of the interest rate. During times of inflation, interest rate may escalate rapidly. This will result in a corresponding increase in related ARM rate, which might create payments larger than the borrower had envisioned.
Consumers also need to be aware of potential rate errors or overcharges, whether intentional or not.
The best time for a borrower to consider an ARM is if rates are high, but trending lower. This will keep the borrower’s payments lower over the life of the loan. ARMs are also preferable if the borrower plans on holding the home for a shorter period of time.
Finally, ARMs work well if the borrower wants to keep their initial payments lower in anticipation of high income in the future when larger payments are more feasible.
An ARM may be worth a closer look if you expect to sell, move, or refinance before the introductory fixed-rate period ends. It can also fit borrowers who want lower initial payments and have enough room in their budget to handle a possible increase later.
A fixed-rate mortgage may be a better fit if you expect to keep the home for many years, want predictable payments for the long term, or would feel financially stretched if the rate resets higher. Before choosing an ARM, compare your expected time in the home, your refinancing plans, and your comfort with future payment uncertainty.
Sammamish Mortgage can help. We serve clients across Washington, Idaho, Colorado, Oregon, and California. Since 1992, we’ve been providing several mortgage programs and products with flexible qualification criteria to borrowers across the Pacific Northwest. Visit our website to get an instant rate quote or to use our online mortgage calculator. Or, reach out to us if you are ready to get pre-approved for a mortgage.
An adjustable-rate mortgage, or ARM, is a home loan that starts with a fixed interest rate for an introductory period and then can adjust later based on the loan terms. After the fixed period ends, the new rate is generally calculated using an index plus a lender margin.
Once the introductory fixed-rate period ends, the loan moves into its adjustment phase. The interest rate can change according to the index named in the loan documents, the lender’s margin, the adjustment schedule, and any rate caps that limit how much the rate can change.
The index is a market-based benchmark used to help determine the new interest rate. The margin is the number of percentage points the lender adds to that index. Together, they are generally used to calculate the adjusted rate after the fixed introductory period ends.
That depends on the loan terms. Some ARMs adjust every six months, while others adjust once a year. The timing and frequency of adjustments are listed in the loan disclosures.
The main drawback is payment uncertainty after the fixed period ends. If market rates rise, the loan’s interest rate and monthly payment may increase. Borrowers also need to review their loan terms carefully so they understand how adjustments work and can watch for possible servicing errors or overcharges.
Rate caps limit how much an ARM’s interest rate can change. A periodic cap limits how much the rate can change at each adjustment after the first reset, while a lifetime cap limits how much the rate can increase over the full life of the loan.
It depends on your plans and risk tolerance. An ARM may fit better if you want a lower initial payment and expect to sell, move, or refinance before the first adjustment. A fixed-rate mortgage may be a better fit if you want long-term payment stability or expect to keep the home for many years.
An ARM can make sense for borrowers who are comfortable with some future rate uncertainty in exchange for a lower starting rate. It may be a reasonable option if you expect to move or refinance before the rate adjusts, or if you have enough room in your budget to handle a higher payment later.
After the initial 5-year fixed period ends, the loan begins adjusting based on the terms in the mortgage documents. The new rate is generally tied to the loan’s index and margin, and any increase or decrease is subject to the loan’s adjustment caps.
Yes, many borrowers consider an ARM because they expect to sell, move, or refinance before the introductory fixed-rate period ends. That can help them take advantage of the lower initial rate while avoiding later adjustment risk, although timing and eligibility can vary.
Our loan officers are ready and waiting to help you apply for your home loan.
Learn more about the people behind Sammamish Mortgage
Whether you’re buying a home or ready to refinance, our professionals can help.
Mortgage Support — 24/7
No Obligation and transparency 24/7. Instantly compare live rates and costs from our network of lenders across the country. Real-time accurate rates and closing costs for a variety of loan programs custom to your specific situation.
Adjust the parameters based on what you want to track
