An adjustable-rate mortgage (ARM) is a home loan whose interest rate can change over time.
A Longer Definition: Adjustable-Rate Mortgage
An adjustable-rate mortgage (ARM) is a mortgage where the interest rate remains fixed for a certain number of years – usually 5 or 7 – and then changes annually or semi-annually for the loan’s remaining loan term.
Adjustable interest rates are an optional mortgage feature and strictly regulated to protects homeowners and lenders from rising rates and PITI, which can spark mortgage default and foreclosure.
ARM starting interest rates average 0.64 percentage points lower than comparable fixed-rate mortgages, which yields $450 in annual savings per $100,000 borrowed. Approximately 10 percent of home buyers choose an adjustable-rate option.
ARMs are available for conventional mortgages, FHA mortgages, and VA mortgages, but not USDA mortgages; and ARMs can be used to finance all types of residential homes, including houses, condos, multi-units, and manufactured homes.
How Adjustable-Rate Mortgages Work
An adjustable-rate mortgage is based on a standard fixed-rate mortgage contract. Its only difference is how its mortgage rate behaves.
With an ARM, the home buyer selects how many years until the loan’s first interest rate adjustment. Five years is the most common selection, which creates a 5-year ARM.
Home buyers can also choose 3-year ARMs, 7-year ARMs, and 10-year ARMs.
Next, the lender assigns a mortgage rate. Then, the loan is given a margin and an index.
The margin is a constant used to find future interest rate adjustments. The index is the variable by which the adjustable rate adjusts.
When an ARM adjusts, its new interest rate is the sum of the margin plus the index, so long as the sum falls within given limits.
ARM limits are known as caps.
Caps hold ARM interest rates within a safe, controlled range. A typical cap prevents rates from moving up or down by more than 2 percentage points.
Caps on a 5-year ARM look like this:
- After five years, the adjustment is capped at ±5 percentage points
- Every year after, the adjustment is capped at ±2 percentage points
Non-conforming ARMs, including jumbo and portfolio loans, may use different indexes, margins, and caps. Ask your lender for details.
5-Year ARM Savings At Today’s Mortgage Rates
| Loan Size |
5-Year Savings |
| $75,000 |
$2,926 |
| $100,000 |
$3,902 |
| $125,000 |
$4,877 |
| $150,000 |
$5,852 |
| $175,000 |
$6,828 |
| $200,000 |
$7,803 |
| $225,000 |
$8,779 |
| $250,000 |
$9,754 |
Data: Homebuyer.com, based on today’s mortgage rates.
Adjustable-Rate Mortgages Types
The majority of adjustable-rate mortgages are issued via Fannie Mae or Freddie Mac. Other ARM types also exist. Let’s review them all.
The Hybrid ARM
Hybrid mortgage ARMs are another name for conventional mortgage ARMs. It’s name “hybrid” refers to the loan’s adjustment schedule, which causes it to resemble a fixed-rate mortgage for a few years and then an adjustable-rate mortgage later.
The standard Hybrid ARM margin is 2.75 percent, and its index is often set to the 1-year Constant Maturity Treasury. Conventional ARMs are structured as 5-Year ARMs most commonly.
The FHA ARM
FHA ARMs are a variation of the standard FHA mortgage. FHA ARMs adjust after every year in their 30-year loan term, with a mandated interest cap of 1 percentage point per year and five percentage points over the life of the loan.
The VA ARM
The VA ARM is similar to the FHA ARM. It’s a variation of the standard VA mortgage. VA ARMs adjust once annually throughout their 30-year loan term and carry a VA-mandated interest cap of 1 percentage point per year and five percentage points over the life of the loan.
The Interest-Only ARM
Interest-only ARMs are adjustable-rate loans whose standard payment does not include a principal balance component. Government regulation reduced the availability of interest-only loans between 2008-2012.
Today, Interest Only ARMs are only available from local banks as specialty products.
Payment Option ARM
Payment option ARMs were retired in 2008 for poor performance. Sometimes called Option ARMs, they were adjustable-rate loans that let homeowners choose from four payment options – full payment, partial payment, interest-only payment, and minimum payment. .
When To Use An Adjustable-Rate Mortgage
There are two scenarios when homeowners should look to choose an ARM.
Scenario 1: Use an ARM when you’re selling or refinancing within five years
When you know that you will sell your home within five years or are confident that you will refinance your mortgage, a 5-year ARM can reduce your mortgage rate and save you money on your home loan.
Scenario 2: Use an ARM when you’re comfortable sharing interest rate risk with your lender
ARMs can provide lower starting interest rates compared to fixed-rate loans. However, interest rates adjust after the loan’s initial teaser period. If you are comfortable with the possibility of changing mortgage interest rates, ARMs can be an intelligent financial decision.
Scenario 3: Don’t use an ARM if the idea of an ARM makes your worry
ARMs can be an effective money-management tool, but not if it comes at the expense of lost sleep. Don’t use an ARM if having an adjusting mortgage worries you. No amount of savings will make up for your discomfort.
Commons Questions About Adjustable-Rate Mortgages
What is a “Toxic ARM?”
Between 2005-2008, some mortgage lenders sold ARMs known as Payment Option ARMs. Payment Option ARMs let homeowners choose from monthly payment options for the first five years. Many homeowners chose the least costly option, adding additional principal to the home’s existing loan balance.
When home values started to drop, a clause in the Option ARM paperwork triggered a reset. Homeowners’ new payments spiked, and large numbers of homes went into foreclosure.
For the damage they did to the mortgage ecosystem, Payment Option ARMs are now known as Toxic ARMs.
Are ARMs safe?
Adjustable-rate mortgages are safe when used responsibly. Starting interest rates are lower than fixed-rate mortgages, and interest rate caps prevent rapidly rising payments.
Are ARMs better than fixed-rate mortgages?
ARMs are neither better nor worse than fixed-rate mortgages. ARMs may be right for you if you plan to sell or refinance within five years of purchase or if you like to share the time risk of your loan.
Are fixed-rate mortgages safer than ARMs?
Fixed-rate mortgages are not safer than ARMs. The benefit of a fixed-rate mortgage is that you know what your exact mortgage payment will be for the next 30 years. In exchange for that certainty, you’ll pay a higher mortgage rate. Fixed-rate mortgages aren’t safer – they’re more certain.
Can my ARM interest rate jump to 20% overnight?
No, because of caps, your ARM can’t change overnight or go to 20 percent. ARMs can only adjust after the initial starting period ends and on subsequent anniversaries. And, when ARMs adjust, they can only change by a few percentage points at a time.
Can you refinance an adjustable-rate mortgage?
Homeowners can refinance an ARM or fixed-rate mortgage at any time. However, ARMs don’t constantly adjust higher. Before refinancing your ARM, compare your upcoming adjusted interest rate to today’s mortgage rates. If today’s rates are higher, do not refinance your ARM.
