What is an adjustable-rate mortgage (ARM)?

Adjustable-rate mortgages (ARMs) usually offer a lower initial interest rate, making them attractive to buyers looking to reduce their monthly payment. This lower interest rate doesn’t last forever. Like the name implies, the rates on these mortgages begin to adjust at a certain point based on market conditions. The intervals at which they adjust are dictated by the terms of your mortgage, and the amount of the adjustment may be uncertain. Taking time upfront to understand how ARMs work can help prepare you if your rate starts to climb.

Let’s take a closer look at adjustable-rate mortgages and how they work, how rates are determined, different types of ARMs – including the meaning of a 7/6 ARM – the benefits and drawbacks of ARMs, how to qualify for one, and whether you are a good candidate for this financing.

ARM definition

An adjustable-rate mortgage is a financing option that offers a lower starting interest rate than comparable fixed-rate loans. This rate remains fixed for a set number of years before periodically shifting based on market trends. This means your monthly payments can change over time. ARMs are available as conventional loans and jumbo loans (a type of nonconforming loan). They’re also available as conventional loans like VA loans, and FHA loans.

ARMs include interest rate caps – limits on how much the rate can rise during the first adjustment, each following period, and over the entire life of the loan – to provide a level of protection against unpredictable market spikes.

ARMs are typically advertised as a figure with two numbers. The first number tells you the length of time that your initial interest rate will remain the same, and the second number tells you how often your interest rate will change after that. For example, a 5/1 ARM would have a fixed interest rate for five years and then adjust once per year after the initial rate period ends.

ARM vs. fixed-rate mortgage

Here’s a chart that compares these two loan options:

Adjustable-rate mortgages are different from fixed-rate mortgages. The latter maintains a constant interest rate and offers predictable monthly principal and interest payments over the entire life of the loan. The former feature rates that shift after an initial fixed period.

ARMs usually offer lower introductory rates than fixed-rate loans, providing immediate savings that can be helpful if you plan to sell or refinance within a few years. But once the introductory period concludes, ARM rates adjust periodically based on market conditions. That means your monthly payments could increase or decrease over time.

Ultimately, fixed-rate loans provide long-term stability and a shield against rising rates. ARMs offer short-term affordability with a higher degree of future risk.

How does an ARM work?

ARMs are long-term home loans with two periods: a fixed period and an adjustable period. These two periods significantly affect your monthly payments and total interest costs.

• Fixed period: During the fixed period, your interest rate does not change, and this typically lasts for 3, 5, 7, or 10 years.
• Adjustment period: After the fixed-rate period expires, your interest rate can go up or down based on changes in the market. With many ARMS, your interest rate will generally adjust either every 6 or 12 months.

For example, if you take out an ARM with a 5-year fixed period, the interest rate would be fixed for the first 5 years of the loan. After that, your rate would adjust up or down for the remaining 25 years of the loan, if you’ve opted for a 30-year term.

To protect borrowers from extreme market volatility, ARMs include interest rate caps that limit how high a rate can rise. This is often indicated by a three-number sequence, such as 2/2/5. In this example, it signifies an initial adjustment cap of 2% for the first adjustment after the fixed period, a subsequent adjustment cap of 2% for every following adjustment, and a lifetime cap of 5% that restricts the total increase over the entire duration of the loan. It’s essential to understand these thresholds because, while most lenders adhere to a 5% lifetime limit, some may set higher caps. You want to ensure your budget can handle the maximum potential monthly payment if rates reach those peaks.

ARMs also have an interest rate floor, which guarantees that the interest rate never drops below a specific level, no matter how low market rates fall. This safeguard provides essential security for lenders by guaranteeing a baseline level of profit, even during periods of major economic decline.

These different features and ARM costs are shown in your loan estimate.

How are ARM rates determined?

The interest rate you are offered on a mortgage will depend on a variety of factors, including your:

• Personal financial factors like your credit score.
• Property details, including price, location, and type.
• Loan details, such as the amount, term, interest rate type, and down payment.
• Overall market conditions.

With an ARM, lenders use two other figures to determine how your interest rate will adjust after the fixed period ends: the index and the margin. The index is a market-based interest rate, such as the prime rate or the secured overnight financing rate (SOFR), that changes over time, while the margin is a specific number set by your lender when you take out your loan.

Index rate + Margin = Your mortgage interest rate

Types of ARMs

There are three common types of ARMs you can choose from. We’ll walk you through each of them.

Hybrid ARMs

A hybrid ARM gives you a mortgage rate that stays locked in at the beginning, then starts adjusting later. These are the most common forms of adjustable-rate mortgages and include:

• 5/1 ARMs: A fixed interest rate for the first 5 years, followed by a rate that adjusts once a year.
• 5/6 ARMs: A fixed interest rate for the first 5 years, followed by a rate that adjusts every 6 months.
• 7/1 ARMs: A fixed interest rate for the first 7 years, followed by a rate that adjusts once a year.
• 7/6 ARMs: A fixed interest rate for the first seven years, followed by a rate that adjusts every 6 months.
• 10/1 ARMs: A fixed interest rate for the first 10 years, followed by a rate that adjusts once a year.
• 10/6 ARMs: A fixed interest rate for the first 10 years, followed by a rate that adjusts every 6 months.

Remember, interest rates rise and fall, and there’s no way to know where rates will be when your fixed period ends. If you take out a mortgage with an adjustable interest rate, you should prepare to cover a higher mortgage payment in your budget.

Interest-only ARMs

An interest-only ARM is a type of mortgage that allows borrowers to pay only the interest for a set period of usually 3 to 10 years. After that, the loan amortizes to cover both principal and interest, which means payments increase over the remaining term of the loan. After the fixed-rate period ends, the interest rate may also increase and push payments higher.

 Good candidates for an interest-only ARM include high-income borrowers with irregular cash flow, but there’s a risk if the property doesn’t appreciate or your income doesn’t grow on schedule.

Keep in mind that an interest-only ARM may significantly hinder home equity growth. That’s because your initial payments will not reduce the principal balance, leaving you dependent on market appreciation to increase the ownership value in your property.

Payment-option ARMs

Payment-option ARMs are loans that allow borrowers to choose from several types of payment options. They can usually choose from full principal-and-interest, interest-only, or a smaller minimum payment. While this does give flexible choices, it can be risky.

“However, note that the minimum payment option often falls short of covering your interest owed, so the unpaid portion gets added to your loan balance,” says Andrew Lokenauth, a personal finance expert. “This is called negative amortization, which means your loan grows larger, not smaller,” he says. “This option was pushed heavily before 2008, and its widespread misuse contributed to the financial crisis. I would approach these with serious caution.”

Example of an ARM

Let’s say you want to borrow $350,000 via an ARM over 30 years, with an initial rate of 6.5% and 2/2/5 caps. (The caps mean the rate cannot rise more than 2 percentage points at the first adjustment, no more than 2 points at each adjustment after that, and no more than 5 points above the original rate over the life of your loan.) If so, your starting monthly payments (principal and interest only; property taxes and homeowners insurance not included) would be $2,212 for the first 5 years, then jump to $2,690 per month in year 6, then increase to around $2,940 in year 7.

Here’s how that breaks down:

With an ARM, what you pay every month for a mortgage loan can change a lot when your interest rate resets. You can use this payment calculator from Rocket Mortgage to determine what you might pay.

Pros and cons of ARMs

Adjustable-rate mortgages can be the right choice if you want to enjoy the relatively low rates many lenders offer for the initial period. Among the advantages of ARMs are the following:

• More affordable early payments. The lower introductory rate on an ARM can make homeownership more affordable during the fixed period. This can be especially useful if you expect your income to increase in the coming years.
• Ability to save or invest extra cash. The money you save from your initial lower monthly ARM payments can help you build your savings and work toward other financial goals. You can also use your savings to safeguard your finances if your interest rate spikes after the initial period.
• Pay down your principal faster: Take advantage of your low introductory monthly payments by putting the extra money you save toward your principal loan balance each month to pay off your loan faster.
• Buy a starter home: Many buyers purchase a starter home to enjoy the lower monthly mortgage payments ARMs offer as they plan to upgrade to a larger home. The risks of an ARM are relatively minimal if you can sell the starter home before the interest rate begins adjusting.
• Potential for interest rate decreases. If you took out your ARM during a time when interest rates are relatively high and then they drop before your introductory period ends, your monthly payment may not increase and could even decrease.
• May allow for a bigger home budget. A lower introductory interest rate can decrease your initial monthly debt obligation. That could make you eligible for a larger loan amount, effectively boosting your purchasing power and enabling you to bid on more expensive properties than a fixed-rate mortgage would permit.
• Flexibility for short-term ownership. An ARM may be the best mortgage option if you’re purchasing a home you don’t plan on owning for more than 5 years and are looking for the lowest interest rate on a mortgage.

ARMs also come with potential downsides. Here’s a breakdown:

• Potential rate increases. The biggest risk of an ARM is the potential for your interest rate to increase. If your rate goes up, your monthly mortgage payments will go up, too.
• Less predictable mortgage payments: It can be difficult to budget long-term when your interest rate and monthly payments fluctuate. If your rate rises, you may struggle to make the higher monthly payments. The possibility of future rate adjustments can be a concern for some home buyers.
• Potentially higher overall costs. If rates increase, you may end up paying more overall for an ARM than if you’d initially taken out a fixed-rate mortgage instead.
• Complex terms. “ARMs have more moving parts than fixed loans, including indexes, margins, caps, and adjustment schedules,” says Lokenauth. “Most borrowers don’t understand all of them before signing. That knowledge gap can create financial vulnerability that often doesn’t surface until adjustment day, when it’s too late to do much about it.”

How to qualify for an ARM

The specific eligibility requirements for an ARM will vary depending on the lender you choose. But in general, expect to meet the following qualification criteria:

• Have a minimum credit score of 620 (requirements can vary by loan type and lender. Note that Fannie Mae and Freddie Mac no longer have minimum credit score thresholds for conforming loans which are often sold on the secondary mortgage market.
• Make at least a 5% down payment.
• Have a debt-to-income ratio no higher than 43% to 50%.
• Pay closing costs that range from 3% to 6% of the purchase price.
• Maintain cash reserves.
• Qualify at the fully indexed rate. Lenders confirm your eligibility based on the projected adjusted rate rather than their lower introductory rate.
• Verify proof of previous housing payments. If your credit file is lacking and this is your first home purchase, prepare to furnish 12 months of documented punctual rent or utility payments.

Should you get an ARM?

Getting an ARM can make good sense if you:

• Plan to move soon or refinance before the ARM’s initial fixed rate period ends.
• Expect interest rates to drop in the future.
• Need the lower payment to meet DTI requirements.
• Have a budget that can handle variable mortgage payments and risk.

“High earners with growing income and a strong financial cushion can absorb ARM rate movement without real risk. Buyers in a high-interest-rate environment who expect rates to fall could also benefit from a lower starting point and downward adjustments over time,” Lokenauth continues.

Then again, an ARM may not be in your best interest if you have long-term ownership plans and expect to stay put in your home, need rate certainty and predictability, and want to avoid risk or the need to refinance in the future.

FAQ

Here are answers to some common questions about ARMs.

What’s the difference between conforming and nonconforming ARMs?

Conforming ARMs follow the standard rules set by Fannie Mae and Freddie Mac, including loan limits and underwriting guidelines. Nonconforming ARMs fall outside those rules and often include jumbo loans or more specialized mortgage products. The main difference is that nonconforming loans tend to have more customized terms and sometimes stricter qualification standards, depending on the lender and your borrowing profile.

What happens if I pay off my ARM early?

If you pay off your ARM early, your payment obligation ends and the lender releases its claim on your property. In some cases, there could be a prepayment penalty for paying it off ahead of schedule. But many loans today do not include such a penalty.

How do I apply for an ARM?

Applying for an ARM is much like applying for any other mortgage loan. You’ll typically need to provide documents that show your income, savings, taxes, and credit history so the lender can review your financial picture. From there, the lender decides whether you qualify and which loan options, including adjustable-rate mortgages, make sense for you.

What happens if I can’t afford my ARM after rates reset?

If your payments become too expensive after the rate adjusts, you still have a few options. You can refinance into a different loan, sell your home, ask your lender about modifying the loan, or attempt to work out a more manageable repayment plan. The sooner you attempt a resolution, the better, as lenders are typically far more open to helping early in the process – before borrowers fall seriously behind on payments.

When should I refinance my ARM?

Refinancing your ARM can make sense when rates are favorable, when you want the stability of a fixed-rate loan, or when the first rate adjustment is getting close and you desire more certainty around payments. Many borrowers begin looking at that option before the initial fixed rate period ends, particularly if they have a chance to lock in a steady long-term rate. You can look at today’s interest rates to see if it’s a good time to refinance your ARM.

The bottom line: An ARM can work for some home buyers

Ready to secure a mortgage to buy a home? You’ll need to decide if you prefer a fixed or adjustable interest rate. In many cases, the right answer will depend on your unique financial situation as well as current market conditions. An ARM comes with a lower interest rate to start, but you need to be ready for potentially higher payments once that fixed period ends.

If you think an ARM is right for your unique situation, you can apply for an ARM loan today with Rocket Mortgage.