A Guide to Adjustable-Rate Mortgages (ARMs)

Learn how ARMs work, common types, and whether one could help lower your monthly payment.

Adjustable-rate mortgages (ARMs) are home loans with variable (or adjustable) rates. They are often more affordable for the first few years than their fixed-rate alternatives, but they come with added risks.

This guide to adjustable-rate mortgages, or variable-rate mortgages, will provide insight into how an ARM loan works, as well as the types of adjustable-rate loans and the pros and cons of this borrowing option.

What Is an Adjustable-Rate Mortgage?

An adjustable-rate mortgage is a type of mortgage loan that has a variable rate, so the rate and monthly payments can change over time.

With an ARM, your initial interest rate is locked in (or fixed) for a limited period, such as five or 10 years. After that time, the interest rate moves up or down, based on financial markets and indexes. This causes your monthly mortgage payment to change (higher or lower) -- although there is a limit to how big those changes can be.

ARMs vs. Fixed-Rate Mortgages

There are important differences between adjustable-rate mortgages and fixed-rate mortgages. Understanding the differences will allow you to choose the one that makes most sense for your financial situation and help you save money.

Typically, an adjustable-rate loan will have a lower starting rate than a fixed-rate loan. However, while a fixed-rate loan has the same rate and payments for the life of the loan, the variable interest rate on ARMs means your payment can change after the initial fixed-rate period, as can total borrowing costs.

Here are some of the key differences:

How Do ARMs Work?

The most common adjustable-rate mortgage provides you with an introductory starting rate that lasts for a set time called the fixed period. When the fixed period ends, the loan moves into the adjustable period. Here are the key differences:

• Fixed period. During this time, your rate is fixed and not subject to rate increases or decreases. Fixed periods last several years, depending on the type of ARM you choose.
• Adjustable period. During this time, your rate could increase or decrease. The adjustable period lasts until your loan reaches 30 years. For example, an ARM with a 5-year fixed period will have an adjustable period of 25 years.

Adjustable-rate loans are usually named for the length of the fixed period, as well as based on how often the rate can adjust during the adjustable period.

For example, if you take out a 5/1 ARM, then your initial starting rate is locked in for five years after which time it can adjust once per year.

While ARMs can be risky because your payment can go up or down, there are usually rate caps that limit how much the rate can move with each adjustment and over the life of the loan.

How Rate Caps Work

Rate caps limit the risks associated with an ARM by limiting how much the loan rate can go up with:

• The first adjustment after the fixed period ends. This is the initial cap.
• After each adjustment period. This cap applies for each periodic adjustment.
• Over the life of the loan. This refers to the maximum amount the rate can go up the entire time you have the loan.

For example, let's say your ARM has a 5/2/5 cap structure on a 5/1 ARM.

• Your loan rate is fixed for the first five years
• After five years, the rate begins adjusting but the initial cap applies so it could not increase more than 5% from the fixed rate.
• Your rate could adjust once each year after the first adjustment, but a 2% maximum cap applies to each adjustment.
• Over the entire duration of the loan, the rate cannot go up by more than 5% of the initial fixed rate.

It is important to make sure that you can afford the highest possible payment that could result if your loan rate adjusts up by the maximum possible amount. Remember, adjustments aren’t always up. They can also go down each adjustment period depending on the market. This occurred frequently during the years between 2020 and 2022.

How Variable Rates Work

The initial ARM rate you are offered is determined based on market conditions, your financial credentials (including your credit score), your down payment amount, and your chosen loan type and term.

Once your initial rate expires after the fixed period, then your rate can change. Your loan rate is tied to a fluctuating financial market index and moves with it. The ARM rate is tied to an index that sets the reference rate or index rate.

Your interest rate will usually equal the reference rate plus the margin. The margin refers to the number of percentage points added to the index by the mortgage lender to set your interest rate on the ARM. For example, your loan could be tied to the Secured Overnight Financing Rate (SOFR) or to some other index rate like the prime rate. For example, a 2% margin added to a 5% index rate would result in a loan rate of 7% on the adjustment date. If the index rate drops to 4%, then using the calculation of index rate + margin, the new rate would be 6% on the adjustment date.

As the index rate moves up and down, the margin (the +2%) never changes. But it is possible your payment will fall, or will increase up to the rate caps, as the index rate changes.

Types of Adjustable-Rate Mortgages

There are several different kinds of adjustable-rate mortgages that may be available to you. Let's take a look at each type.

Hybrid ARMs

These are the most common types of ARMs and what Freedom Mortgages offers our customers. They are the type of ARM that’s been explained in the article and have both a fixed period and an adjustable period. The type of loan (5/1 ARM, for example) details how long the fixed period is and how often the rate can adjust during the adjustable period.

Here are some of the most common options for hybrid ARMs.

Interest-Only ARMs

Interest-only ARMs work differently. Here's how they work:

• You can choose to pay only interest for a specific time frame, such as three years to 10 years.
• After the initial period, you must begin paying both the principal and interest.

These loans are not as common as hybrid ARMs and are usually chosen by buyers who want to keep their initial mortgage costs very low. However, they can result in much higher payments later in the life of the loan since you are not paying down your principal balance at all during the early years of borrowing.

Payment-Option ARMs

Payment option ARMs, while not very common, provide the most payment flexibility, however, they are by far the riskiest type of ARM. Here's how they work:

• You have different payment options, including paying a minimum payment that covers a part of monthly interest, a payment that covers just interest (which would be a standard interest-only payment), or a third choice that covers both the interest and principal (a standard monthly mortgage payment).
• Payment-option ARMS could include a 30-year or 15-year fully amortizing payment.
• If you pay the minimum payment only, your principal balance will increase because the unpaid interest will be added to it.

ARM Requirements

Generally, you will need to qualify for an ARM at the maximum cap rate payment if you hope to take out this type of loan. Lenders consider your financial credentials when determining if you are eligible. Here are some ARM requirements:

• Credit score: The minimum credit score for an ARM varies by lender but is usually 580 for FHA loans (or 500 with a larger down payment) and 620 for conventional ARMs.
• Debt-to-income ratio: Lenders follow a maximum DTI set by the type of ARM you choose (such as FHA, VA or conventional). DTI refers to debt payments relative to income. Again, the rules vary by loan and lender but are often around 45%, or 36% for jumbo ARMs. Again, lenders determine your ARM eligibility based on the higher monthly payments that you could face with an adjustable-rate loan, not based on the initial low rate.
• Loan type: Requirements can also differ for different kinds of ARMs, such as hybrid, interest-only, or payment-option ARMs. Freedom Mortgage only offers hybrid ARMs.

Conforming vs. Nonconforming ARM Loans

An ARM could either be a conforming loan or a non-conforming loan. Conforming loans adhere to guidelines that are set by Fannie Mae and Freddie Mac. These two government-sponsored entities (GSEs) are major purchasers of mortgage loans on the secondary market.

Non-conforming loans, primarily jumbo loans, do not meet the Fannie and Freddie guidelines. There is usually more flexibility in terms of eligibility and amount borrowed, but interest rates may be higher (but not always) because of increased risk to lenders since the loans can't be purchased or guaranteed by the GSEs.

Adjustable-Rate Mortgage Considerations

Before you apply for an adjustable-rate mortgage, you need to consider your comfort level with a variable rate loan. Since your rate can change, you risk your housing payment becoming more expensive. This can put a strain on your budget.

If you plan to move or refinance a few years after getting the ARM (primarily during the fixed period), the potential for future rate changes may not be as much of a concern for you. If you can benefit from the lower initial rate of an ARM, this could result in significant saving on interest.

However, if you plan to remain in your home for the long term, you should consider a fixed-rate mortgage to provide more consistency and certainty -- especially if interest rates are going up. Otherwise, you could get stuck paying a higher rate and being unable to refinance to a more affordable loan.

Adjustable-Rate Mortgage Example

Here is an example of what an adjustable-rate mortgage might look like.

• You take out a 5/1 hybrid ARM.
• Your interest rate is fixed for the first five years and is determined based on your credit score, market conditions, and other financial factors. For example, the rate might be 5.25%.
• For five years, your monthly payments are based on the 5.25% rate amortized over 30 years (unless you choose an ARM that amortizes over 15 years, but these are rare).
• After five years, your rate begins adjusting based on the market index your ARM is tied to. If your rate is tied to the prime rate + 2% margin and the prime rate is 5.00%, then your rate would jump up to 7%. Your monthly payments would be reset based on the new rate of 7% instead of 5.25%.
• After a year, your rate would adjust again based on the current prime rate. It could go up or down. Your payment would change accordingly.

Adjustable-Rate Mortgage FAQs

Still need to know more? Here are the answers to some frequently asked questions about adjustable-rate mortgages.

Is an ARM better than a 30-Year Fixed Mortgage?

An ARM may initially have more affordable payments and a lower rate than a 30-year fixed-rate mortgage (which could save you a lot of money). However, ARMs are riskier loans because the rate and payment can change over time.

A 30-year mortgage would benefit a borrower that wants more certainty about how present and future housing costs. If you want the lowest monthly payments and know you will get another mortgage in the next 10 years or less, you may prefer and benefit financially from an ARM. Ultimately, you should speak to a financial professional to weigh all of the potential loan options available to you to make the best decision.

What’s the Main Downside of an Adjustable-Rate Mortgage?

The uncertainty of future rates is the main downside of an adjustable-rate mortgage. Your rate and payment could increase over time, making your loan more expensive each month and over the life of the loan.

Can You Refinance an ARM to a Fixed-Rate Mortgage?

You can refinance an ARM to a fixed-rate mortgage provided that you can qualify for a fixed-rate loan based on your financial credentials and the value of your home. In fact, this is very common for many Freedom Mortgage customers who choose an ARM. You will need to pay closing costs when you refinance, but if these costs are lower than the money you save with your lower rate, an ARM might make financial sense and allow you to pay significantly less interest.

Final Thoughts: Is an Adjustable-Rate Mortgage Right for You?

An adjustable-rate mortgage may be right for you if you are willing to take on more risk in exchange for a lower initial interest rate and monthly payment. An ARM typically makes the most financial sense if you plan to move or refinance before the initial rate expires. Find out how much money you could save with an ARM from Freedom Mortgage today!