Adjustable-rate mortgages (ARMs)

How an adjustable-rate mortgage works

An adjustable-rate mortgage (ARM) keeps one rate for an introductory period, then resets it on a schedule for the rest of the term. Caps limit how far each reset can move the rate, but they do not remove the risk.

• Intro period: a fixed rate for five, seven or ten years
• Reset: the rate then adjusts on a set schedule, often every six months
• New rate: the index plus a margin fixed at closing
• Caps: limits on each adjustment and over the loan's life

In an ARM's name, the first number is the fixed years and the second shows how often the rate adjusts afterward: every six months in a 5/6, once a year in an older 5/1. Read both numbers before comparing offers.

How the new rate is set and capped

At each adjustment, the lender adds your margin to the current index. Most new ARMs use the 30-day average SOFR, which replaced LIBOR as the standard benchmark; the margin is set at closing and does not change.

Caps are written as three numbers, and 2/1/5 is a common structure on 5/6 loans. Your note sets the real limits, so check them before you compare offers.

What an adjustable-rate mortgage really costs

Take a $400,000 loan on a 5/6 ARM with 2/1/5 caps and the example's intro rate (6.73%). The table shows the worst case, where the index stays high enough to hit every cap, against the 30-year fixed average of 7.18%.

The first reset alone moves the rate from 6.73% to 8.73% and the payment from $2,589 to $3,081, a jump of $492. Three more six-month adjustments reach the 5-percentage-point lifetime cap, 11.73%, where the payment sits at $3,862, or $1,273 above the start.

Over the first five years, the ARM saves $7,260 compared with the 30-year fixed in this example. The intro discount is the whole point of an ARM, so when intro rates sit at or above fixed rates, there is no early saving to offset the reset risk.

Why the intro rate is only part of the price

Two ARMs quoted at the same intro rate can reset very differently. The terms that set the later price appear in the lender's ARM disclosure, so compare them before you compare the starting rate:

• Margin: the fixed add-on to the index at every reset
• Cap sizes: a larger first cap allows a bigger first jump
• Adjustment schedule: six-month resets move faster than yearly ones
• Discount points: paid at closing to lower the intro rate

Extra principal during the fixed years is the one lever left after closing, because a smaller balance resets to a smaller payment. A biweekly payment calculator shows how quickly extra payments shrink the balance.

When an adjustable-rate mortgage goes wrong

ARM problems start at the first reset, not at closing. Nobody can forecast where mortgage rates go, so the safe test is whether you can carry the capped payment, not whether rates will help.

• Payment shock: $492 more at the first reset, up to $1,273 at the cap
• Little relief when rates fall: floors often sit at the margin
• Blocked exit: refinancing depends on rates and equity when you need it
• Collateral: missed payments after a reset can lead to foreclosure

Federal rules require lenders to give you the CFPB's Consumer Handbook on Adjustable-Rate Mortgages and a program disclosure at application (Regulation Z § 1026.19(b)). The disclosure lists the index, the caps and how the payment can change, so read it before you choose a rate.

ARM vs. 30-year fixed vs. 15-year fixed

All three finance the same home. They differ in how the rate behaves, what you pay at the start and how bad the later years can get.

Fixed-rate loans trade a possible intro discount for certainty. For the full head-to-head, including when each wins, use the ARM vs. fixed-rate calculator.

Who an adjustable-rate mortgage fits

An ARM fits borrowers who will probably leave the loan before the rate matters, and who could still carry the capped payment if plans change.

• A firm plan to sell or move before the first reset
• An intro rate clearly below the fixed-rate quote
• Income and reserves that cover the capped payment
• Enough equity to refinance if the market allows

Skip it if you plan to stay for decades or your budget has no room above the starting payment. An ARM without an intro discount adds risk and gives nothing in return.

Adjustable-rate mortgages: pros and cons

How lenders qualify you for an ARM

The core tests match a fixed-rate loan: on conventional ARMs, a credit score of 620 or higher and a debt-to-income ratio near 45%, stretching to 50% with strong compensating factors. Other programs set their own limits.

Ask which rate the lender uses to qualify you. Some qualify ARM borrowers above the intro rate, especially on short fixed periods, so the loan you are approved for can be smaller than the intro payment suggests.

Requirements at a glance

• Credit score of 620 or higher on conventional ARMs, depending on the lender
• Down payment set by the program and lender, which can differ from a comparable fixed-rate loan
• Debt-to-income ratio near 45%, up to 50% at some lenders with strong factors
• Income that can carry a payment above the intro payment, since some lenders qualify ARMs at a higher rate
• The lender's ARM program disclosure and the CFPB's ARM handbook, delivered at application
• A written exit plan: sell, refinance or budget for the capped payment