What Is an Adjustable-Rate Mortgage (ARM)?

An adjustable-rate mortgage (ARM) is a type of home loan with a fixed interest rate for a set number of years, after which it switches to a variable rate that may change. And with it, your mortgage rate and monthly payment.

Because adjustable-rate mortgages typically offer a lower starting rate than 30-year fixed-rate loans, they can be a smart choice for homeowners who plan to move or refinance within a few years. Or they can lead to an increasing monthly payment, depending on the loan’s terms and underlying index. 

What is an adjustable-rate mortgage?

An adjustable-rate mortgage (ARM) is a type of home loan with an interest rate that can change over time. 

Unlike a fixed-rate mortgage, which has a constant rate during the entire loan term, an adjustable-rate mortgage typically starts with a fixed rate for a predetermined number of years. After the fixed rate expires, the rate adjusts (typically once or twice a year), based on a benchmark index plus a margin. 

This means your monthly payment can increase or decrease depending on how interest rates are trending. Because of this structure, ARMs can be riskier and usually best if you plan to sell or refinance before the first rate adjustment.

How does an ARM work?

A standard hybrid adjustable-rate mortgage starts with a fixed interest rate that's often lower than fixed-rate loan options. The fixed rate on the ARM typically lasts for three, five, seven, or 10 years, but it varies based on the loan, and some FHA loans offer a one-year introductory rate.

ARMs are described in shorthand — for example, as a 5/6 ARM or a 7/1 ARM. The first number refers to the length of the initial fixed rate period, in years. The second number indicates how frequently the rate adjusts after the initial period — either every six months or each year.

ARM examples

Examples of common hybrid ARMs include:

• 3/6 ARM: The initial rate lasts 3 years; the rate then adjusts every 6 months.
• 3/1 ARM: The initial rate lasts 3 years; the rate then adjusts once a year.
• 5/6 ARM: The initial rate lasts 5 years; the rate then adjusts every 6 months.
• 5/1 ARM: The initial rate lasts 5 years; the rate then adjusts once a year.
• 7/6 ARM: The initial rate lasts 7 years; the rate then adjusts every 6 months.
• 7/1 ARM: The initial rate lasts 7 years; the rate then adjusts once a year.
• 10/6 ARM: The initial rate lasts 10 years; the rate then adjusts every 6 months.
• 10/1 ARM: The initial rate lasts 10 years; the rate then adjusts once a year.

How ARM interest rates work

The variable interest rate on an ARM relies on two key factors:

• Index: The index is a benchmark interest rate. The Secured Overnight Financing Rate (SOFR), and the Constant Maturity Treasury (CMT) rate are indexes commonly used by mortgage lenders offering ARMs. The U.S. prime rate may also be used. 
• Margin: The margin is a fixed, additional percentage that the lender adds to the index to determine your total interest rate. The margin does not change over the life of the loan.

Both the index and the margin should be clearly labeled on any loan estimate you receive from a lender.

What ARM types can you choose?

The standard ARM discussed above is called a hybrid ARM. There are other types of ARMs that the Consumer Financial Protection Bureau (CFPB) warns pose more risk, including:

• Interest-only ARMs: You only pay interest for a set number of years, making your initial monthly mortgage payments smaller and more manageable. However, when the interest-only period ends, your monthly payment increases significantly because you’ll have fewer years to pay back the principal.
• Payment option ARMs: You can choose between the traditional hybrid ARM, an interest-only ARM, or a minimum payment ARM that allows you to make a low initial payment. Opting for the low payment could lead to negative amortization. This means your loan balance could go up, not down, if you don't pay enough to keep up with interest. 

What happens when the rate adjusts?

If your ARM’s rate adjusts, your lender recalculates your interest rate using the current index plus your loan’s margin. 

If the index has increased since the last adjustment, your new rate (and monthly payment) will be higher. If the index has decreased, you may have a lower rate and monthly payment.

That said, how much your rate can change is limited by caps built into your loan:

• An initial adjustment cap restricts how much your rate can change the first time it adjusts. Most lenders set this cap at 2 to 5 percentage points, so your rate cannot be more than 2 to 5 percentage points higher or lower than the initial rate.
• Periodic caps limit changes at each subsequent adjustment. The periodic cap is usually 1 to 2 percentage points different from the original loan.
• A lifetime cap sets the maximum increase or decrease over the life of the loan. Lenders usually set a 5% rate cap, so your rate can't go up or down more than 5 percentage points.

Adjustable-rate mortgage vs. fixed-rate mortgage

The key difference between an adjustable-rate mortgage and a fixed-rate mortgage is how the interest rate works.

Fixed-rate mortgages often start with a slightly higher rate, but both the rate and monthly payment stay consistent throughout the life of the loan. 

Adjustable-rate mortgages often start with a lower rate, but the rate can change over time. With high rate caps (rates may increase five percentage points from the starting rate), ARMs can become significantly more expensive in the long run.

The table below shows an example of a 7/1 adjustable-rate mortgage and a fixed-rate mortgage, both with 30-year terms.

Because you can’t actually predict whether rates will go up or down, you will not know your total borrowing costs with an ARM. 

However, every loan estimate for an adjustable-rate mortgage must list the minimum and maximum payments throughout the life of the loan. Look for these numbers in the “projected payments” section to understand potential costs.

When does an ARM make sense?

ARMs make the most sense in the following two scenarios:

• You expect to sell or refinance before the loan’s rate can adjust.
• You expect your income to substantially increase before the loan’s rate can adjust.

If you only plan to keep the loan for a few years, an ARM can be a good choice.

“In my experience, that tends to be relocation buyers, buyers with a clear resale timeline, or higher-end borrowers who want a lower initial payment and have a realistic refinance or exit plan before the first adjustment,” says Alexei Morgado, a Florida Realtor and founder and CEO of Lexawise, a real estate exam prep company. 

Another scenario when an ARM can make sense is if you expect your income to increase before the fixed term expires. For instance, an ARM might be appropriate for a new doctor completing their residency within a few years. 

“ARMs can be a smart tool in the right situation, but only when the buyer’s timeline is clear, and the risk after adjustment is fully understood,” says Morgado.

Pros and cons of an adjustable-rate mortgage

Adjustable-rate mortgages have some benefits for the right borrowers, but consider potential pitfalls before moving forward.

Details on the pros

• Low initial interest rate: An ARM's low starting rate is often one of its biggest advantages. Locking in a low rate for several years can save you money and make your monthly payment more manageable.
• Potential for rate decrease: Theoretically, rates can go down with an ARM. It all depends on the market. Your rate can drop if the benchmark rate goes down.
• More affordable short-term ownership or investment: If you know you’ll sell the house within a few years, an ARM's introductory rate can keep monthly costs down.

Details on the cons

• Interest rate can increase: Once the fixed-rate period ends on a hybrid ARM, your interest rate can shift up or down every 6 months or 1 year. These frequent changes can be stressful and can end up costing you more money in the long run.
• Unpredictable future payments: With a fixed-rate mortgage, you know what your monthly payment will be for the life of the loan. With an adjustable-rate mortgage, there's no clear way to predict what your loan will cost.
• Potential for negative amortization: If you choose a minimum payment option, your loan balance may increase over time if your monthly payment isn't enough to cover interest
• Moving/refinance risks: Many homeowners take on an ARM with the intention of refinancing or selling the home before the rate begins adjusting. But there’s no guarantee you’ll be able to refinance or sell your home quickly, especially if your home loses value.

“A lot can happen over the course of a few years," says R.J. Weiss, certified financial planner and founder of The Ways to Wealth. “Interest rates can change, but so can someone’s income situation, and so can their debt-to-income ratio due to unexpected expenses.” Changes like these, in turn, could make it more difficult or even impossible to refinance.