An adjustable-rate mortgage, or ARM, has an interest rate that fluctuates periodically over the life of the loan. This type of loan sometimes offers borrowers lower initial rates in exchange for future variability based on market conditions.
It’s riskier than a standard fixed-rate mortgage, but savvy homebuyers can use these mechanics to their advantage.
Here, we’ll discuss everything you need to know about ARMs — what an ARM loan is, the common types, and whether choosing one is a good option for you.
What is an adjustable-rate mortgage (ARM)?
An adjustable-rate mortgage (ARM) is a type of home loan where the interest rate can go up or down based on market conditions. The most common ARM loans begin with a set interest rate over an introductory, or “teaser,” period (usually three, five, seven, or 10 years), after which the rate adjusts at regular intervals, typically every six months or yearly.
💡 Understand how to read ARM loans: Let’s take, as an example, a 7/1 ARM loan. Usually, the number preceding the slash signifies the fixed-rate period (7 years), and the number after the slash represents the period between each rate adjustment (yearly, in our case). If you see “6” after the slash, it means the rate adjusts every six months.
The initial teaser rate for ARMs is typically significantly lower than that of fixed-rate mortgages, making this loan attractive to homebuyers who plan to sell the property or refinance before the adjustment period begins.
What are the main types of ARM loans?
There are three main categories of adjustable-rate mortgages to know:
Hybrid ARM loan
The most common type of adjustable-rate home loan, a hybrid ARM combines a fixed-rate period at the beginning of the term with an adjustable-rate period for the remainder. A common example is a 5/1 ARM loan, where the initial rate is fixed for five years and then adjusts annually after that.
Interest-only ARM
An interest-only ARM allows the borrower to pay only interest for a set period, without any principal payments. While this keeps monthly payments very low, you’re not paying anything toward your mortgage principal balance during that time, meaning no equity is earned unless the property becomes valued higher. When the adjustment period begins, the monthly payments will increase significantly to cover both interest and principal.
Payment-option ARM
More a thing of the past, this type of ARM loan offers borrowers the opportunity to choose from different payment options: an interest-only payment, a standard payment with principal and interest, or a minimum payment. This type of loan requires the borrower to have a sound financial understanding. For example, selecting minimum payments may result in negative amortization, which will increase the loan balance.
How does an ARM work?
A typical ARM loan has two distinct periods in its life: a fixed introductory period followed by an adjustment period:
- Fixed period: During this time, a borrower will pay a low, unchangeable rate for a set term (such as five years in a 5/1 ARM).
- Adjustment period: After the introductory period is over, the rate will reset regularly — typically, annually or semi-annually, reflecting changes in financial markets and the economy.
When the fixed period ends, payments may go up or down — sometimes significantly. To protect both borrowers and lenders, ARM loans have rate caps. There are generally three types of rate caps:
- Initial adjustment cap: Limits the amount the interest rate can change the first time, after the introductory period ends, typically 2% or 5%.
- Periodic adjustment cap: Determines how much the interest rate can change at each subsequent adjustment period.
- Lifetime cap: Limits the change in the interest rate over the entire life of the loan.
How ARM variable rates are determined
The lender adjusts the ARM rate based on a specific market index, usually the Secured Overnight Financing Rate (SOFR) or Cost of Funds Index (COFI). On top of the index, a lender adds a fixed margin — typically around 2–3%, although the exact number depends on the lender and your financial situation when you initially fill out the loan application.
For example, say the current index rate is 4.20% and the margin is 3%. If the fixed period were to end today, your interest rate would be 7.20%.
How the fixed initial rate is set
The initial rate (also called a “teaser” rate) is typically offered below standard market rates to attract borrowers and increase affordability throughout this period. The lender will set this rate as part of the loan terms, often considering factors such as your credit score, loan-to-value (LTV) ratio, and general market conditions.
Pros and cons of ARM loans
If you’re trying to decide whether an ARM loan is right for you, make sure you understand its main benefits and drawbacks, including:
✅ Pros
- Lower initial rates
- Potential for lower payments after the introductory period
- Good for short-term ownership
- Flexibility to refinance
❌ Cons
- Uncertainty after the fixed period ends
- The interest rate could rise significantly
- It could be more expensive in the long run
- More complicated terms and budgeting
Typically, borrowers opt for ARMs to take advantage of lower payments initially — for instance, if their financial situation is anticipated to improve substantially over the next few years, or if they intend to sell the property before the end of the introductory period. However, ARM loans may not be the best option for risk-averse homebuyers, those who want to live in the home longer than the intro period, or those who prefer simpler loan terms.
Choosing an ARM over a fixed-rate mortgage
If you want to see whether an ARM or a fixed-rate mortgage would be better in your particular situation, take a look at a side-by-side comparison of their main features and key differences.
| Characteristic | Adjustable-rate mortgage (ARM) | Fixed-rate mortgage |
|---|---|---|
| Initial interest rate | Typically lower | Usually higher |
| Monthly payments | Low at first, may shift over time | Remain constant |
| Rate changes | Can increase or decrease after the initial period | No change; rate is locked for the entire life of the loan |
| Payment predictability | Less predictable after adjustment | Predictable all the time |
| Risk level | Higher risk (possible increases) | Very low risk |
| Best for | Short-term owners, those expecting higher income or a rate drop | Long-term owners seeking stability |
| Typical loan holder | Young professional borrowers with higher risk tolerance | Older, moderate-income borrowers |
The ultimate decision on whether an ARM loan is the right move for you depends on your current and projected financial situation, your tolerance toward changing rates, and whether you plan to stay in the property for a longer period.
You can refinance from an ARM to a fixed-rate mortgage in the future if you’d like to move to more predictable monthly payments and protection against rising interest rates. However, it would require applying for a new loan and paying closing costs again.
Bottom line: Don’t get an ARM loan without a plan
ARMs offer lower initial costs than their fixed-rate counterparts, but they demand careful consideration and financial planning from the borrower. Study the rate caps, shop around (both lender and ARM types), and consult with an expert when deciding whether an adjustable-rate mortgage is ideal for your circumstances.
And if you need assistance when house-shopping, Clever Real Estate can help. At Clever, you can connect with top real estate professionals in your area who can help you with every step — from applying for a mortgage to preparing an offer a seller can’t refuse.