Adjustable-rate mortgages (ARMs): How do they work and what’s the benefit?

A mortgage is a loan specifically intended to help you pay for a house. One of the major decisions you’ll have to make when taking out a mortgage is to choose between a fixed-rate loan and an adjustable-rate loan. A fixed-rate mortgage has an interest rate that never changes, while an adjustable-rate loan, on the other hand, has an interest rate that fluctuates based on market indexes.

First-time buyers may wonder why they would ever choose to have a mortgage with a variable rate over one with a fixed interest rate. In short, adjustable-rate loans are risky, but can have lower interest rates for years — which means lower monthly payments. Mortgage lenders also set limits or caps as to how much the interest rate can rise. Additionally, there are hybrid adjustable-rate mortgages that combine both types of mortgage: you pay a fixed rate for a period of time and then a variable rate for the remaining period of time.

Often, the interest rates during the fixed period are lower than with traditional 30-year fixed-rate mortgages, which can be enticing. An adjustable-rate mortgage with low interest rates at the outset means more of your monthly payment can go toward paying down the mortgage balance, and that means you build equity faster.

However, this may only be a short-term benefit of the ARM, since the interest rate can increase significantly. If you don’t have a plan for the variable-rate phase of the mortgage, getting an ARM may not be the best idea since you’re assuming a lot of risk.

In this article:

• How does an adjustable-rate mortgage (ARM) work?
• Types of adjustable rate mortgages
• How are interest rates set for adjustable-rate mortgages?
• How high can adjustable-rate mortgage interest be?

How does an adjustable-rate mortgage (ARM) work?

Your mortgage consists of the principal and interest as well as other costs like mortgage insurance, homeowners insurance, and taxes. The interest is what makes an adjustable-rate mortgage differ from a fixed-rate mortgage.

With an ARM, you’ll make a monthly mortgage payment, but the amount is subject to change based on the interest rate. That doesn’t mean every monthly payment will be radically different than the next — the lender will adjust the interest rate periodically depending on the agreement of your loan. That means you might have a lower payment for a period of time, like a year, and then a much higher mortgage payment the following year.

You can learn more about how mortgage payments are applied here and see today’s mortgage rates here.

Types of adjustable rate mortgages

There are a few types of adjustable-rate loan products. Mortgages can get confusing, but just make sure to understand how a hybrid ARM works, which we’ll focus on for this article since they're the most common.

Hybrid ARMs

Hybrid ARMs are the most widely available type of variable-rate mortgage today. As the name suggests, this type of mortgage loan has both a fixed rate and a variable rate.

During an initial fixed-rate period, the mortgage interest rate stays the same for a specified period of time. (For example: five years for a 5/1 ARM or seven years for a 7/1 ARM.)

After the initial fixed-rate period ends, the interest rate will adjust periodically, depending on your mortgage loan terms. The mortgage interest rate might change monthly, quarterly, annually, or even every three years or five years. (For example, with a 5/1 ARM, the interest rate can change once a year.)

Lenders may use the bottom number to express things a little differently, so be sure to ask them about it. (For example, you may see a 2/28 ARM, which has a fixed rate for two years and then a variable rate 28 years.)

Learn more about the 5/1 ARM.

Interest-only ARMs

With an interest-only mortgage, you only pay interest for a set period of time (usually three to 10 years) before you start making higher payments during the rest of the mortgage term. After the interest-only payment period, the rates can change in the same ways as other adjustable-rate loans.

Learn more about interest-only loans here and if they’re ever worth it.

Payment-option ARMs

This type of mortgage loan has mostly been phased out over the years since the housing crisis. With payment-option ARMs, the borrower can choose different ways to make their monthly mortgage payment, like an interest-only payment, a traditional payment (principal plus interest), or a minimum payment.

How are interest rates set for adjustable-rate mortgages?

Most mortgage lenders use a similar method for determining the interest rate based on indexes and margins.

Indexes

Financial indexes track and measure the general performance and changes in interest rates. The lender will base the annual percentage rate on one of a few major indexes. The most common indexes used for mortgage rates are the Cost of Funds Index (COFI), the London Interbank Offered Rate (Libor), and the cost of one-year Treasury bills.

As the index rises or falls, expect your rates to adjust accordingly. You can ask the lender which index they use and track its performance online or in the newspaper. Even though the indexes adjust frequently, usually day to day, your mortgage rates will only adjust based on the terms (monthly, annually, etc.) we mentioned before.

Margins

Next the lender will add a margin. The margin is a set percentage that stays the same over the course of the loan. It varies by lender, but might be dependent on your credit score. The margin is added to the indexed rate. For example, the lender sets a margin of 2%. If the indexed rate is 4% then your actual interest rate (called the fully indexed rate) would be 6% (4% + 2%).

Some lenders will use another formula or way to decide your interest rate, so be sure to ask them how the interest rates are determined and how the indexes or margins are applied.

How high can adjustable-rate mortgage interest be?

Adjustable-rate loans also come with caps, which are consumer safeguards used to protect the borrower from extreme raises in the interest rate. Rate caps come in a few different forms.

Lifetime rate caps restrict how much the interest rate can change over the entire course of the loan. For example the total interest rate adjustment might not be allowed to exceed 6% during the lifetime of the loan.

Periodic rate caps limit how much the interest rate can change from one adjustment period to the next. For example, the lender might state that the interest rate cannot adjust more than 2% a year or that they cannot adjust the interest rate more than 1% every six months.

Payment caps restrict how much your mortgage payment can increase. Even if the interest rate goes up, your monthly payment won’t exceed whatever amount. For example, mortgage has a payment cap that says your mortgage payment can’t increase more than 7.5% in a given year. It is possible for an ARM to have both an interest rate cap and a payment cap.

Payment caps may sound nice, but have a significant downside. Any interest you didn’t pay because of the cap could carry over into the next adjustment period and add to your loan balance. That means your loan balance could actually end up greater than what you started with, resulting in negative amortization. However, payment caps (and negative amortization features) have mostly been phased out of the mortgage industry but make sure to check your agreement.

Benefits and disadvantages of an adjustable-rate mortgage

The general advantage of an adjustable-rate mortgage is a potentially lower interest rate. A lower interest rate means more of your monthly payment can go toward paying down the principal balance of the mortgage — which results in faster amortization and more equity in your home. Hybrid ARMs generally have lower interest rates during the initial fixed-rate period than your standard 30-year fixed-rate mortgage — which can make the hybrid ARM enticing for homebuyers.

However, you run the risk of your monthly payments skyrocketing once the initial fixed period ends. If interest rates unexpectedly rise and you’re not financially prepared to account for the sudden increase, you could default on your loan payments and ultimately lose your home to foreclosure. When you set out getting a mortgage loan, it's important to know the maximum monthly payment you can afford. One way to do this is by using our mortgage calculator to get an estimate.

Similarly, borrowers should be aware of adjustable-rate mortgages with short-term interest rates (non-hybrid ARMs) or an introductory rate that seems too good to be true. These teaser rates are very low for a brief period of time before the fully indexed rate kicks in. These loans usually come with higher closing costs to make up for the discounted rate.

Of course, there’s the possibility that your monthly payment for an ARM mortgage might actually get smaller based on the indexes. But the length of a mortgage loan is not at all short, so it’s hard to assess what might happen in the next decade or three. Know how much risk you want to take when it comes to mortgage rates. A fixed-rate mortgage on the other hand would give you predictable equal payments for the entire loan term.

Adjustable-rate mortgages may be advantageous for borrowers who don’t plan to stay in the home long. If you plan to flip or sell the house while the interest rates are low at a fixed rate, then a hybrid ARM might make sense. But, keep in mind there’s no guarantee that you’ll be able to sell or successfully refinance your mortgage.

Adjustable-rate mortgage contracts are also more complex than fixed-rate loan contracts, since there are more payment variables. If you’re not financially savvy, a fixed-rate mortgage might be a better idea since it's more straightforward. Your interest rate might be higher than you’d like, but at least you would have security in your payment schedule and you don’t have to worry about what’s happening with market indexes.