Adjustable-rate mortgages: What they are and how they work

When you get a mortgage, you can choose a fixed interest rate or one that changes. While fixed-rate mortgages keep the same rate and payment for the life of the loan, adjustable-rate mortgages (ARMs for short) have an introductory fixed-rate period, followed by fluctuating rates that change how much you pay. Typically, ARM loan rates start lower than their fixed-rate counterparts, then adjust upwards once the introductory period is over.

Here’s everything you need to know about ARMs: what they are, how they work and when you should take one up.

What is an adjustable-rate mortgage (ARM)?

An adjustable-rate mortgage, or ARM, is a home loan that has an initial, low fixed-rate period of several years. After that, for the remainder of the loan term, the interest rate resets at regular intervals. This means that the monthly payments can go up or down.

Generally, the initial interest rate on an ARM mortgage is lower than that of a comparable fixed-rate mortgage. After that period ends, interest rates — and your monthly payments — can rise or fall.

Interest rates are unpredictable, though in recent decades they’ve tended to trend up and down over multi-year cycles. During periods of higher rates, ARMs can help you save money in the early days of your loan by securing a lower initial rate. Just keep in mind that after the introductory period of the loan, the rate — and your monthly payment — might go up.

The initial interest rate on an adjustable-rate mortgage is sometimes called a “teaser” rate, and ARMs themselves are sometimes referred to as “teaser” loans. While they’re generally one and the same, there can be a difference between a regular ARM and a riskier teaser loan that offers an extremely discounted rate upfront, followed by a dramatic change (usually upward) in the rate.

Fixed-rate vs. adjustable-rate mortgages

The difference between fixed-rate and adjustable-rate mortgages is simple: Fixed-rate mortgages have the same rate for the life of the loan, whereas ARMs have a rate that moves up or down after an introductory period. Other than that, they work similarly: You pay them off each month, in payments that include principal and interest and sometimes homeowners insurance and property taxes.

“Deciding between a fixed-rate mortgage and an ARM is about picking stability or flexibility,” says Linda Bell, principal writer for Bankrate’s Home Lending team. “With a fixed-rate mortgage, you get a steady interest rate and you know how much you’ll pay each month. On the other hand, the initial low rate you get with an ARM could mean lower payments early on. However, as market rates change, make sure you are prepared for potential increases down the road.”

How does an adjustable-rate mortgage work?

ARMs are comprised of a few components:

• Fixed period: This is the period with the low introductory (and fixed) rate, which lasts for three to 10 years, depending on the loan. In an ARMs-naming convention, this is the first number (for instance, the “7” in “7/1”).
• Adjustable period: The adjustable period starts after the fixed period ends, continuing until you sell, refinance or pay off the loan.
• Rate of adjustment: ARMs adjust every six months to a year. This is the second number in the name (the “1” in “7/1” or the “6” in “5/6″). You may see variations of this, such as a 5/5 ARM, which is an ARM that adjusts every five years.

What are ARM rate caps?

ARMs come with rate caps that insulate you from possible steep year-to-year increases in monthly payments. These caps limit the amount by which rates and payments can change.

• A periodic rate cap: Limits how much the interest rate can change from one year to the next.
• A lifetime rate cap: Limits how much the interest rate can rise over the life of the loan.
• A payment cap: Limits the amount the monthly payment can rise over the life of the loan in dollars, rather than how much the rate can change in percentage points.

Adjustable-rate mortgage example

Let’s say you took out a 30-year 5/1 ARM for $350,000 with an introductory rate of 6.65 percent (the average rate as of this writing). Here’s how your payment schedule might look, assuming interest rates rose annually by. 25 percent. The ARM has a lifetime cap of 12 percent.

Types of ARMs

ARMs are generally 30-year mortgages, but they can vary a lot in how often the fixed rate lasts and how often the rates change once you’re into the variable-rate period. Here are the most typical loan terms:

• 3/6 and 3/1 ARMs: 3/6 and 3/1 ARMs have a fixed introductory rate for the first three years of the mortgage, then switch to an adjustable rate for the remaining 27 years. 3/6 ARMs adjust every six months, whereas 3/1 ARMs adjust yearly.
• 5/6 and 5/1 ARMs: 5/6 and 5/1 ARMs offer a fixed intro rate for the first five years of the mortgage, then switch to an adjustable rate for the remaining 25 years. 5/6 ARMs adjust every six months, and 5/1 ARMs adjust yearly.
• 7/6 and 7/1 ARMs: 7/6 and 7/1 ARMs come with a fixed intro rate for the first seven years of the mortgage, then move to an adjustable rate for the remaining 23 years. 7/6 ARMs adjust every six months, and 7/1 ARMs adjust yearly.
• 10/6 and 10/1 ARMs: 10/6 and 10/1 ARMs have a fixed intro rate for the first 10 years of the mortgage, then move to an adjustable rate for the remaining 20 years. 10/6 ARMs adjust every six months, and 10/1 ARMs adjust yearly.

Along with these common loan terms, there are three main types of ARMs: hybrid, interest-only and payment-option.

Hybrid ARM

A hybrid ARM is the traditional adjustable-rate mortgage. The loan starts with a fixed interest rate for a few years (usually three to 10), and then the rate adjusts up or down on a preset schedule, such as once per year.

Interest-only ARM

Interest-only ARMs are adjustable-rate mortgages in which the borrower only pays interest (no principal) for a set period. Once that interest-only period ends, the borrower starts making full principal and interest payments.

The interest-only period might last a few months to a few years. During that time, the monthly payments will be low (since they’re only interest), but the borrower also won’t build any equity in their home (unless the home appreciates in value).

Payment-option ARM

With a payment-option ARM, borrowers select their own payment structure and schedule, such as interest-only; a 15- 30- or 40-year term; or any other payment equal to or greater than the minimum payment. (The minimum payment is based on a typical 30-year amortization with the initial rate of the loan.)

A payment-option ARM, however, could result in negative amortization, meaning the balance of your loan increases because you aren’t paying enough to cover interest. If the balance rises too much, your lender might recast the loan and require you to make much larger, and potentially unaffordable, payments.

Is an adjustable-rate mortgage right for you?

There are several reasons why an ARM may be the right choice for you:

• Lower monthly payments at the start. With an ARM, you’ll get a lower initial interest rate, translating to lower monthly payments and the potential to allocate more money toward the principal.
• More budget flexibility. With a lower monthly payment at the beginning, you could choose to pay more when you have extra cash and less when you need money for other things.
• You’re going to sell or refinance. ARMs are generally ideal for borrowers who don’t plan to stay in their home long-term or aim to refinance after a few years. You can take advantage of the low intro rate, then end the mortgage before the rate adjusts.

However, if you’re going to stay in your home for decades, an ARM can be risky. If you don’t refinance, your mortgage payments may rise significantly once the fixed-rate period ends. If you’re buying your forever home, think carefully about whether an ARM is right for you.

Adjustable-rate mortgage FAQ

• How are variable rates on ARMs determined?

  Most ARM rates are tied to the performance of one of three major indexes:

  • Weekly constant maturity yield on one-year Treasury bill: The yield debt securities issued by the U.S. Treasury are paying, as tracked by the Federal Reserve Board
  • 11th District cost of funds index (COFI): The interest financial institutions in the western U.S. are paying on deposits they hold
  • The secured overnight financing rate (SOFR): The most common benchmark rate for ARMs, a replacement for  the London Interbank Offered Rate (LIBOR)

  Your loan paperwork identifies which index a particular ARM follows.

  To set ARM rates, mortgage lenders take an index rate and add a stated number of percentage points, called the margin. The index rate can change, but the margin does not.

  For example, if the index is 4.25 percent and the margin is 3 percentage points, they are added together for an interest rate of 7.25 percent. If, a year later, the index is 4.5 percent, then the interest rate on your loan will rise to 7.5 percent.

• What are the requirements for an adjustable-rate mortgage?

  The basic requirements for an ARM loan include a credit score of at least 620 and a debt-to-income ratio (DTI) of 50 percent or less. Further requirements depend on whether you get a conventional, FHA or VA ARM loan.

• Can I convert my ARM to a fixed-rate mortgage?

  Refinancing an ARM to a fixed-rate mortgage is a fairly common thing to do. Keep in mind that refinancing isn’t free, though — you’ll pay closing costs, just as you did on your original loan. Ideally, to recoup those costs, you want to refinance to a significantly lower rate, shortening your break-even period.