The lower starting rate on an adjustable mortgage can be tempting. The real question is what happens to your payment when the fixed period ends.
With a fixed-rate mortgage, the interest rate on day one is the rate on the last day. With an adjustable-rate mortgage, or ARM, the rate is fixed for a few years and then follows the market.
How an ARM is built
Every ARM has three moving parts:
- An introductory period, commonly five, seven or ten years, when the rate is fixed.
- An index, a published market rate. Many newer loans use SOFR.
- A margin, a fixed number of percentage points the lender adds to the index.
After the introductory period, your rate becomes the index plus the margin, recalculated on a schedule. A 5/6 ARM, for example, is fixed for five years and then adjusts every six months.
The caps that limit changes
Caps are written as three numbers, such as 2/1/5:
- 2: the most the rate can rise at the first adjustment.
- 1: the most it can rise at each later adjustment.
- 5: the most it can ever rise above the starting rate.
Example: an ARM starting at 5.75% with 2/1/5 caps could reach 7.75% at the first adjustment and never go above 10.75%.
Test the worst case
Ask the lender to show the payment at the lifetime cap. On a $350,000 loan, if the rate eventually climbed to the 10.75% cap, the principal-and-interest payment would be more than $1,000 a month higher than at the start. If that would break your budget, the ARM’s early savings may not be worth the risk.
A useful rule: an ARM fits best when you’re confident you’ll sell or refinance before the fixed period ends, and you’d still cope if those plans changed.
When a fixed rate makes more sense
- You plan to stay in the home for many years.
- Your income is steady but not likely to grow quickly.
- You’d rather know your payment for the life of the loan.
Rates are only part of the cost. The Loan Estimate shows how an ARM’s payments can change over time, and it’s covered in our walk-through of the Loan Estimate and Closing Disclosure. For how payments are split between principal and interest, see what’s inside a mortgage payment.
The short version
- A fixed rate stays the same for the life of the loan; an adjustable rate changes after an introductory period.
- ARM rates are set as an index plus a margin, limited by caps.
- Before choosing an ARM, make sure you could afford the payment at the lifetime cap.
Readers also ask
What does 5/6 mean?
The rate is fixed for five years, then can adjust every six months.
Which index do newer ARMs use?
Many use the Secured Overnight Financing Rate, known as SOFR.
Can I refinance out of an ARM later?
Often, yes, but refinancing has costs and depends on your credit, income and home value at the time.
This guide is general information about U.S. mortgages, not financial, tax or legal advice. Loan terms depend on the lender and on your credit, income and property, so confirm the details with your lender, and see consumerfinance.gov for official guidance.
