Adjustable Rate Mortgages (ARM)

How ARMs Work

Every ARM has two phases. First is the initial fixed period, when your rate doesn't change. This can last 3, 5, 7 or 10 years. The starting rate is often lower than a comparable 30-year fixed rate.

Next comes the adjustment period. After the fixed period ends, your rate can go up or down at regular intervals, usually every six months or once a year, based on market conditions. Your payment changes along with it.

Most ARMs today are still 30-year loans overall, so you'll pay on the same timeline as a fixed-rate loan. Only the rate behavior is different.

Before you choose an ARM, ask yourself one question: what's my plan when the fixed period ends? If the answer is selling, refinancing or paying the loan down, an ARM can fit nicely.

Index, Margin and Caps

When your ARM adjusts, the new rate is calculated with a simple formula: index + margin = your new rate.

• Index: A market benchmark that moves up and down. Most new ARMs use the Secured Overnight Financing Rate (SOFR).
• Margin: A fixed number of percentage points added to the index. It's set when you get the loan and never changes.
• Caps: Limits that protect you from big jumps. There's usually an initial cap (the most the rate can change at the first adjustment), a periodic cap (the most it can change at each later adjustment) and a lifetime cap (the most it can ever rise above your starting rate).

Caps are often written as three numbers, like 2/1/5. In that example, the rate could change up to 2 points at the first adjustment, 1 point at each adjustment after, and 5 points total over the life of the loan. Knowing your caps lets you calculate your worst-case payment in advance, which I always recommend.

Common Types (5/6, 7/6, 10/6)

ARM names tell you how they behave. The first number is the length of the fixed period in years. The second number tells you how often the rate adjusts after that. A "6" means every six months.

• 5/6 ARM: Fixed for 5 years, then adjusts every 6 months.
• 7/6 ARM: Fixed for 7 years, then adjusts every 6 months.
• 10/6 ARM: Fixed for 10 years, then adjusts every 6 months.

Generally, the shorter the fixed period, the lower the starting rate. A longer fixed period costs a little more upfront but gives you more years of certainty.

Pros and Cons

Pros:

• Lower starting rate and payment compared with many fixed-rate loans
• Can help you qualify for a larger loan or free up monthly cash
• Great for buyers who expect to sell or refinance before the fixed period ends
• If market rates fall, your payment can go down without refinancing

Cons:

• Your payment can rise, sometimes significantly, after the fixed period
• Harder to budget long term
• Plans change. If you end up staying longer than expected, you take on rate risk

An ARM can be a smart tool when it matches your timeline. I'll show you the payment at the start, at the first adjustment and in the worst case, so you know exactly what you're signing up for.