A lower mortgage rate can make buying a home more affordable — but what if that rate isn’t guaranteed to last? That’s the tradeoff with an adjustable-rate mortgage (ARM).
ARMs typically offer lower initial rates than fixed-rate mortgages, which can mean a lower monthly payment during the first few years of your loan. After that initial period, however, your rate can rise or fall — and your payment can change along with it.
For some homebuyers, particularly those who expect to sell or refinance before the rate begins adjusting, an ARM could save money. For others, the uncertainty of future rate increases may outweigh the upfront savings.
Understanding how ARMs work, including when rates adjust and how much they can increase, can help you decide whether one fits your budget and homebuying timeline.
What is an adjustable-rate mortgage (ARM)?
An adjustable-rate mortgage (ARM) is a type of home loan with an interest rate that can change periodically after an initial fixed-rate period. Your rate stays the same during the introductory period, which can last several years. After that, it adjusts at set intervals based on a benchmark interest rate, or index, specified in your loan terms. When your interest rate changes, your monthly principal and interest payment can change, too.
ARMs work differently from fixed-rate mortgages, which have an interest rate that’s locked in for the life of the loan. With a fixed-rate mortgage, your rate and monthly principal and interest payments stay the same, making your payments more predictable.
An ARM typically starts with a lower interest rate than a comparable fixed-rate mortgage, which can mean lower payments at first. However, your rate — and monthly payment — could increase after the fixed period ends. ARM rate caps limit how much the interest rate can increase at each adjustment and over the life of the loan.
How does an adjustable-rate mortgage work?
ARMs start with a fixed period during which your interest rate won’t change. When your rate adjusts, your lender uses a benchmark called an index, such as the Secured Overnight Financing Rate (SOFR), and adds a set percentage called the margin. Together, the index and margin determine your new interest rate, subject to the limits outlined in your loan agreement.
If the index rises, your rate and monthly principal and interest payment may increase. If it falls, they may decrease. However, ARM rate caps limit how much your interest rate can change at one time and over the life of the loan.
“Most ARMs have caps built in so there is a ceiling on how high it can go, but even with those caps a meaningful jump in rate can really put pressure on a monthly budget,” says Travis Erickson, mortgage broker at Bonelli Financial Group.
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Understanding ARM terms and structure
To fully understand how an ARM works, you need to familiarize yourself with the following terms and how they interact with one another.
Initial fixed period
ARMs are typically described using two numbers separated by a slash, such as 5/6, 7/6 or 10/6. The first number tells you how many years your initial interest rate is fixed. The second indicates how often the rate can adjust afterward.
For example, a 5/6 ARM has a fixed rate for five years and can then adjust every six months. A 5/1 ARM also has a five-year fixed period but can adjust once per year after that.
Index and margin
Once an ARM enters its adjustable period, your interest rate is generally determined by two components:
- Index: A benchmark interest rate that reflects broader market conditions. Many ARMs today use the Secured Overnight Financing Rate (SOFR).
- Margin: A set percentage your lender adds to the index.
For example, if the index is 4% and your lender’s margin is 2.5%, your fully indexed rate would be 6.5%, subject to any applicable rate caps.
Adjustment frequency
At each scheduled adjustment, your lender recalculates your rate based on the loan’s index and margin. Depending on your loan terms, your rate could increase, decrease or stay the same.
Your lender must provide notice before your first payment at the adjusted rate is due, giving you time to prepare for a potential change in your monthly payment.
Rate caps
The interest rate on an ARM won’t increase indefinitely; there are restrictions on ARM rates and adjustments. There are three main types of rate caps:
- Initial adjustment cap: Limits how much your rate can increase the first time it adjusts after the fixed period ends.
- Periodic adjustment cap: Limits how much your rate can increase at each subsequent adjustment.
- Lifetime cap: Limits how much your rate can increase above the initial rate over the life of the loan.
How much can your ARM payment increase?
Even with rate caps, an ARM adjustment can significantly increase your monthly mortgage payment. How much depends on your remaining loan balance, the new interest rate and the number of years left on your mortgage.
Let’s say you take out a 5/1 ARM for $300,000 with a 30-year repayment term and an initial rate of 7%. Your monthly principal and interest payment would be about $1,996 for the first five years.
If your rate increased to 9% after that fixed period ends, your lender would recalculate your payment using your remaining loan balance and 25-year repayment period. Your monthly principal and interest payment would rise to about $2,381 — an increase of roughly $385 per month.
Your ARM’s rate caps would determine how quickly your rate could rise and the maximum rate you could pay over the life of the loan. For example, over the life of the loan, your rate wouldn’t go higher than 12% if you had a 5% lifetime cap.
Adjustable-rate vs. fixed-rate mortgage
The biggest difference between a fixed-rate mortgage and an adjustable-rate mortgage is predictability versus potential upfront savings. A fixed-rate mortgage keeps the same interest rate for the entire loan term, while an ARM typically offers a fixed rate for several years before it begins adjusting.
A fixed-rate mortgage may be a better fit if you prefer predictable payments, are uncomfortable with the possibility of rising rates or plan to stay in your home for many years. Your principal and interest payment won’t change, although your total monthly payment can still fluctuate as property taxes and homeowners insurance costs change.
“If you are buying your forever home and want to know your payment is locked in forever, a fixed rate makes all the sense in the world,” says Erickson.
An ARM may make more sense if it offers a meaningfully lower initial rate and you expect to sell the home before the fixed-rate period ends. It can also be worth considering if you expect to refinance, although you shouldn’t count on refinancing as your only strategy — future rates and your ability to qualify aren’t guaranteed.
“If you know you are going to sell or refinance within the next five to seven years, with a 30-year fixed [mortgage], you are paying for security you are never going to need,” says Erickson.
Pros and cons of adjustable-rate mortgages
ARMs can offer a lower initial rate and monthly payment than fixed-rate mortgages, but those upfront savings come with the risk that your rate and payment could increase later. Consider these advantages and disadvantages before choosing an ARM.
Pros
- May have a lower initial interest rate than a fixed-rate mortgage
- Lower initial rate can mean lower starting monthly payments
- Potential to save if interest rates stay low or fall
- Can be useful if you plan to sell before the fixed-rate period ends
- Rate caps limit how much your interest rate can increase
Cons
- Interest rate and monthly payments can increase over time
- Less predictable than a fixed-rate mortgage
- More complex loan structure
- Could cost more over the long term if rates rise
- May be risky if you can’t comfortably afford a higher payment
How to qualify for an ARM
To qualify for an ARM, you’ll need to meet a lender’s underwriting requirements. Lenders often evaluate these factors:
- Credit score: You usually need a minimum credit score of 620 to 640, though criteria varies by lender. A stronger credit score can help you qualify for a better rate.
- Debt-to-income ratio: Lenders also consider how much of your monthly income is already going toward debt payments to make sure you can afford the mortgage. They usually prefer a DTI below 36% to 50%.
- Income and savings: Your income, employment and cash reserves are also taken into account when you apply for a mortgage. Since monthly payments on an ARM can increase, lenders may take a more cautious approach when evaluating your finances.
- Down payment: You usually need to provide a down payment of at least 3% to 5%. A higher down payment can snag you a better interest rate, while a down payment of 20% or more is required to avoid private mortgage insurance (PMI).
It’s worth shopping around for a mortgage to find the best rate. According to research from Freddie Mac, checking your rates with multiple lenders could save you $600 to $1,200 per year.
Tips for managing an adjustable-rate mortgage
If you have an ARM, these strategies can help you prepare for future rate and payment changes:
- Know when your rate can adjust: Review your loan documents so you know when the fixed period ends, how often your rate can change and what rate caps apply.
- Budget for a higher payment: Don’t assume your initial payment will last. Consider how much your payment could increase and whether your budget could comfortably absorb the difference.
- Keep an eye on your index: Knowing which index your ARM follows, such as SOFR, can give you an idea of whether your rate may increase or decrease at the next adjustment.
- Review adjustment notices: Your lender or servicer will notify you before your payment changes. Check the new rate and payment and make sure they align with your loan terms.
- Consider refinancing: If you want more predictable payments, you may be able to refinance into a fixed-rate mortgage. Compare the new rate and closing costs with the cost of keeping your ARM before deciding.
Bottom line
An adjustable-rate mortgage can be a smart way to take advantage of a lower initial rate, particularly if you expect to sell before the fixed-rate period ends. But don’t choose an ARM based on the starting payment alone. Make sure you could still afford the mortgage if your rate and payment increase.
Before deciding, compare ARM and fixed-rate offers side by side, including the initial rate, monthly payment, adjustment schedule and rate caps. If predictable payments are your priority or you expect to stay in the home long term, a fixed-rate mortgage may be worth the higher initial rate. If an ARM offers meaningful savings and its potential payment increases fit comfortably within your budget, the tradeoff may be worthwhile.
FAQs about adjustable-rate mortgages
What does a 5/1 ARM mean?
A 5/1 ARM comes with a fixed rate for five years, followed by a variable rate that adjusts once per year.
Are adjustable-rate mortgages risky?
Adjustable-rate mortgages can be risky because interest rates can increase, causing your monthly payments and total borrowing costs to go up. However, ARMs typically come with rate caps that limit how much the interest rate can rise.
Can you refinance an ARM?
Yes, you can refinance an ARM if you can meet a lender’s credit, income and other requirements. You may choose to refinance to a fixed-rate loan if you want predictable monthly payments and long-term loan costs.
Do ARMs always go up?
No, the interest rates on ARMs can go up or down, depending on market conditions.
Is an ARM cheaper than a fixed-rate mortgage?
ARMs often start with lower interest rates than fixed-rate mortgages, but the rate can increase over time. The total cost depends on several factors, including how rates change in the future and how long you keep the loan.
Does your credit score affect an adjustable-rate mortgage?
Your credit score can affect the interest rate and terms you’re offered when you initially apply for an adjustable-rate mortgage. However, changes to your credit score after you close won’t cause your ARM rate to increase or decrease.