Adjustable-Rate Mortgage (ARM)
An adjustable-rate mortgage (ARM) features a changing interest rate. Learn how initial teaser rates, adjustment caps, and market indices affect monthly payments.
Definition
An adjustable-rate mortgage (ARM) is a home loan whose interest rate isn't locked in for the entire term. Most ARMs start with a lower fixed rate for a set period (often three, five or seven years) before shifting to a variable rate that resets periodically based on an index such as the Secured Overnight Financing Rate (SOFR) plus a lender’s margin. Borrowers typically enjoy lower initial payments, but the rate and monthly payment can rise or fall over time, making budgeting more complex. Caps limit how much the rate can increase per adjustment and over the life of the loan, offering some protection. ARMs appeal to buyers who expect to move or refinance before the adjustment period, or who anticipate falling interest rates, but they carry the risk of higher payments if rates rise.
Why It Matters
The risk in an ARM is not the teaser rate, it is the first reset. A 5/1 ARM starting at 5.5% with 2/2/5 caps can legally reach 7.5% in month 61 and 10.5% over the life of the loan, which on a $600,000 balance is roughly $1,900 more per month. If you planned to sell or refinance before that date and the market does not cooperate, you own that payment anyway.
Examples
A buyer takes a 7/1 ARM at 5.25% planning to sell in five years. A job change keeps her in the house another nine, and the rate resets twice before she moves.
On a $500,000 loan, the index plus a 2.75% margin computes to 8.4% at the first adjustment, but a 2% periodic cap holds the new rate at 7.75%, adding about $640 to the monthly payment.
Two lenders quote the same 6.0% start rate. One caps lifetime increases at 5 points over start, the other uses a hard ceiling of 9.75%. In the worst case that gap is worth roughly $200 a month.
Tips
Find the caps line on page 4 of the Loan Estimate and calculate the payment at the maximum rate before you sign. If that number does not fit your budget, the loan does not fit either.
Ask which index the loan follows and what the margin is. The margin never changes, so it is the part of your future rate you are locking in today.
Check whether the loan re-amortizes over the remaining term at reset. A rate increase that also compresses the payoff period raises the payment more than the rate change alone suggests.
Related Terms
Variable Rate Mortgage
A variable rate mortgage, also called an ARM, has interest rates that fluctuate. Understand caps, in...
Fixed-Rate Mortgage
A fixed-rate mortgage keeps the same interest rate for the loan’s life. Learn how predictable paymen...
Balloon Mortgage
A balloon mortgage has small initial payments followed by a large final payment. Learn the pros and ...
Ready to Use Your Real Estate Knowledge?
Now that you understand Adjustable-Rate Mortgage (ARM), let Wayber help you navigate your real estate journey. Our flat-fee service saves you thousands while providing expert guidance.