What is an Adjustable-Rate Mortgage (ARM)? 

Buying a home is a big financial commitment. That means the mortgage you choose can have a big impact on how much interest you pay over time.

One option, a fixed-rate mortgage, is simple to understand: it offers the same interest rate throughout the term of the loan. Meanwhile, an adjustable-rate mortgage (ARM) is a little more complex.

Here’s what you need to know about ARMs.

ARMs can be a popular mortgage choice when interest rates are high. And if you only plan to stay in your home for a few years, they can be an option worth considering as long as you sell your home before the rate changes.

If you have a higher tolerance for rate variability in general, an ARM could also be a good choice for you.

Before deciding on an ARM for your mortgage, make sure you understand these key points:

1. The fixed period is the length of time you keep the initial interest rate, while the adjustment frequency is how often the rate changes afterwards. For instance, a 5yr/6m ARM will have a fixed rate for the first five years, and then will adjust twice a year after the fixed period ends. Note: To get maximum benefit from an ARM’s lower initial rate, look for a fixed period of five years or more.
2. The index is what the lender bases its rate adjustments on, often either the prime rate or SOFR (Secured Overnight Financing Rate). The margin is how much the lender will add to the index when adjusting your rate. The total of the two is typically rounded to the nearest 0.125%. For instance, if the 6-month SOFR rate is 1.8% and the margin is 2.25%, the new rate would be 4.00%.
3. The ARM terms will include how low the rate can go (the floor), how high your rate can increase the first 6 months after the fixed period ends (the initial cap), how much it can increase with each successive adjustment (the subsequent cap), and how much your rate can increase during the life of the loan (the lifetime cap). For instance, an ARM with caps of 2/2/5 means:
   • 2 = The rate will not increase or decrease by more than 2% for the first adjustment after the fixed period ends.
   • 2 = The rate will not increase or decrease by more than 2% for any subsequent rate adjustments.
   • 5 = The rate will never increase by more than 5% above the initial starting rate.

Before you choose an adjustable-rate mortgage, take a hard look at your current budget and consider your potential for future income increases. Make sure you could comfortably afford your monthly mortgage payments if your interest rate was ever to reach the lifetime cap; otherwise, there could be major financial implications.

Also, consider how long you plan to live in the home. Is it a starter home or a forever home? Those buying a starter home might find an ARM more appealing since they won’t be in the house long enough to feel the effects of the adjustable-rate change.