Adjustable-rate mortgage: Definition, types and how it works

If you’re shopping for a home, you may come across a lot of mortgage options. And one of them might be an adjustable-rate mortgage (ARM). 

An ARM is a type of home loan where the interest rate could change after an initial period. But there’s more to ARMs than their interest rates, and it may help to understand how they work before deciding to apply for one. 

Key takeaways

• An ARM is a type of home loan that can have a fluctuating interest rate.
• ARMs usually have an initial period with a fixed mortgage rate. After the initial period ends, the mortgage rate might change. 
• ARM loans can be appealing for their initial lower interest rates. But they can come with some risks too.

An ARM is a type of mortgage where the interest rate can go up or down during the life of the loan. ARMs generally have an initial fixed-rate period that transitions to an adjustable-rate period—sometimes called a variable-rate period—when the interest rate can change. As an ARM’s interest rate adjusts, mortgage payments may also increase or decrease. 

Adjustable-rate vs. fixed-rate mortgages

Another common type of home loan is a fixed-rate mortgage—also called a fixed-rate loan. With a fixed-rate mortgage, the interest rate doesn’t change throughout the loan’s term. Mortgage payments are also typically stable with a fixed-rate mortgage. 

Now you know that an ARM typically offers an initial fixed interest rate followed by an adjustable rate. How long each rate lasts depends on the loan structure and how a lender determines its ARM rates.

How are ARM loans structured?

An ARM’s loan structure depends on the length of the loan’s initial period and how often the adjustable rate changes.

A mortgage lender may offer an initial period of 1, 3, 5, 7 or 10 years. During this time, there’s a set interest rate and monthly mortgage payment. But during the adjustable-rate period, the interest rate could change every six months or every year, for example. 

To help you understand the structure, consider a 7/1 ARM:

• The first number describes the loan’s initial period. In this example, the initial period is seven years.
• The second number describes how often the interest rate will change after the initial period is over. In a 7/1 ARM, the interest rate changes each year.

How are ARM interest rates determined?

Lenders determine how to adjust an ARM’s interest rate by adding what’s called the index and margin. 

An index—the prime rate, for example—is an interest rate based on fluctuations in the housing market. When a person finances their home with an ARM, their lender will decide which index to reference and typically won’t change it.

A margin is the number of percentage points a lender will add to the index after the initial period ends. Lenders usually set the margin and won’t change it.

Some lenders may also apply an interest rate cap. An interest rate cap typically restricts how high an interest rate can get during an ARM loan’s adjustable-rate period. Often expressed as percentage points, it’s generally the maximum amount a lender may increase the previous interest rate.

There are a few types of ARM loans, including:

• Hybrid ARMs: These are some of the more common types of ARMs. Hybrid ARMs start with a fixed rate that then switches to an adjustable rate. For example, a 5/1 hybrid ARM means the rate is fixed for five years and will change every year.
• Interest-only ARMs: With an interest-only ARM, borrowers pay only the interest for the initial period. After that period ends, monthly payments start going toward the principal loan balance.
• Payment-option ARMs: Borrowers who select a payment-option ARM may choose from several payment options, like an amount to cover the principal and interest. Lenders may not offer payment-option ARMs as widely as they used to, though.

If you’re interested in an ARM, you may want to consider its potential pros and cons. 

ARM pros

• Lower initial interest rates: During the initial period, an ARM typically offers a lower interest rate than a fixed-rate mortgage does. Some lenders may offer a teaser rate that’s even lower.
• Lower initial monthly payments: There may also be a lower monthly payment during an ARM’s initial period. A lower monthly payment could mean more money to put toward the mortgage principal or other financial goals, like retirement, a new car or an education fund.
• Flexibility: ARMs could be a flexible loan option for a starter home or if you may be moving soon. In that case, you could take advantage of an ARM’s initial period to save on the total cost of the mortgage.

ARM cons

• Interest rate increases: Even though it’s possible for interest rates to go down, they may go up during the loan’s adjustable-rate period. This could increase the monthly payment and overall mortgage costs. 
• Little predictability: With an ARM, borrowers may not be able to accurately predict the interest rate or mortgage payments during the adjustable-rate period. This could be a challenge for homeowners with a less flexible budget. 
• Limited time to refinance or sell: Borrowers hoping to sell or refinance their home before the initial period is up could be short on time. And then they could end up having to make loan payments during the ARM’s unpredictable adjustable-rate period. 

Compared to fixed-rate mortgages, ARMs may offer a lower initial interest rate and more flexibility. But they’re generally not without their risks. Mortgage rates could increase, and a borrower may experience an unexpected change in their finances. 

Strengthening your credit could help you secure the best rates on an ARM and other types of credit. And if you have an ARM, creating an emergency fund could help you navigate any increases in the interest rate.