Adjustable-Rate Mortgage (ARM)

Adjustable-Rate Mortgage (ARM)

Key takeaways
* An adjustable-rate mortgage (ARM) is a home loan with an interest rate that is fixed for an initial period and then adjusts periodically based on a benchmark index plus a fixed margin.
* ARMs typically start with lower rates than comparable fixed-rate mortgages but expose borrowers to future rate increases.
* Common ARM types include hybrid ARMs (e.g., 5/1), interest-only ARMs, and payment-option ARMs.
* Important features to check before signing: index, margin, adjustment frequency, caps (periodic and lifetime), and any payment caps that could cause negative amortization.

What is an ARM?
An adjustable-rate mortgage (ARM), also called a variable- or floating-rate mortgage, has an interest rate that changes after an initial fixed period. The adjusted rate equals a benchmark index (such as the prime rate, SOFR, or short-term Treasury rates) plus a fixed lender margin. The index can move up or down with market conditions; the margin remains constant.

How ARMs work
An ARM has two main phases:
* Fixed period — the introductory rate remains unchanged for a set time (commonly 2, 3, 5, 7, or 10 years).
* Adjustment period — the rate resets at predetermined intervals (monthly, annually, every five years, etc.) based on the index plus margin.

Other features that affect cost and risk:
* Conforming vs. nonconforming: conforming loans meet standards for sale to Fannie Mae/Freddie Mac; nonconforming loans do not.
* Rate caps: limits on how much the rate can rise per adjustment and over the life of the loan.
* Payment caps and negative amortization: if a payment cap prevents the monthly payment from covering interest, unpaid interest may be added to the principal (negative amortization).

Types of ARMs
* Hybrid ARMs — Combine a fixed initial period with a variable period. Notation like 5/1 means 5 years fixed, then adjusts every 1 year. Example: 2/28 = 2 years fixed, then variable for 28 years.
* Interest-only (I-O) ARMs — Borrower pays only interest for a set time (often 3–10 years), then begins paying principal plus interest, which can cause a large payment increase.
* Payment-option ARMs — Offer multiple payment choices (full principal+interest, interest-only, or a minimum payment). Minimum payments may produce negative amortization and growing principal.

Advantages and disadvantages
Advantages
* Lower initial interest rate and monthly payment compared with many fixed-rate loans.
* Useful if you plan to sell or refinance before adjustments begin.
* Extra cash flow early on can be used for other goals or investments.

Disadvantages
* Future payments are unpredictable; rising market rates increase monthly payments.
* More complex loan terms (indexes, margins, caps) require careful review.
* Risk of large payment increases after introductory or interest-only periods; potential negative amortization with payment caps.

How the variable rate is calculated
After the fixed period ends, the new rate = index + margin. For example, if the index is 2% and the margin is 2.5%, the mortgage rate becomes 4.5%. Although the index changes, the margin set by the lender does not. Lenders must disclose the index, margin, adjustment frequency, and any caps.

Rate caps to know
* Periodic cap — maximum change at each adjustment (e.g., 2% per year).
* Lifetime cap — maximum increase over the life of the loan (e.g., 5% above the initial rate).
* Payment cap — limits how much the monthly payment can change; if insufficient to cover interest, unpaid interest may be added to the principal.

ARM vs. fixed-rate mortgage
* Fixed-rate mortgage: interest rate and monthly payment remain constant for the life of the loan — predictable but usually starts at a higher rate.
* ARM: lower initial rate but exposes borrower to future rate volatility. ARMs can be advantageous for short-term ownership or when you expect higher income or falling rates, while fixed-rate loans suit borrowers who value stability.

Is an ARM right for you?
An ARM may suit you if:
* You plan to sell or refinance before the adjustable period begins.
* You expect your income to increase and can absorb future payment rises.
* You are comfortable with risk and have an emergency fund to handle higher payments.

An ARM may be a poor choice if:
* You need predictable monthly payments.
* You cannot handle significant payment increases or negative amortization risk.

What to check before you sign
* Exact index and how it’s calculated.
* Lender margin.
* Initial fixed period and adjustment frequency.
* All caps (periodic, lifetime, and payment caps).
* Whether the loan allows negative amortization.
* Prepayment penalties and any other fees.

Bottom line
ARMs offer lower initial rates and can make sense for buyers with short-term plans or flexible finances, but they carry the risk of higher future payments and more complex terms. Read disclosures carefully and compare scenarios (including worst-case rate increases) before committing. If unsure, consult a mortgage professional or financial advisor.