Adjustable Rate Mortgages (ARMs): How they can work for you

Jason Kauffman | September 27, 2022

Adjustable Rate Mortgages (called ARMs) haven’t really been a common loan product in the marketplace since the late 2000’s. Because of this, many people have forgotten how they work and when they might be the right fit for your situation.

The reason ARMs have been so uncommon in recent years is that 30 year fixed interest rates have been so low for so long. There is a reasonable rate of return that a mortgage lender expects to receive and once 30 year interest rates dropped below 5%, the rates on ARM’s didn’t go lower than the rates on 30 year money. Consequently, ARMs weren’t being made outside of banks making portfolio loans.

Now that interest rates have risen again, we’re seeing a resurgence of ARM products hitting the market. This is prompting us to revisit how Adjustable Rate loans work.

How do ARMs work?

Most ARMs have a fixed rate at the beginning of the term of the loan. The fixed rate period can vary, but typical fixed rate periods are 3, 5, 7, and 10 years. This means that the initial rate that you lock in is fixed for this period of time after you close on your loan. Most people understand this because this is what drives your initial mortgage payment when you get an adjustable rate loan.

Choosing which period to go with tends to align with the period of time a person thinks they might own the home. If you think you will only live in a home for 5-7 years, then you may be willing to accept a lower interest rate (compared to a 30 year fixed loan) by going with an ARM. Some buyers are willing to accept a lower fixed rate for a shorter period of time because they are comfortable with where the payments could go to once the rate becomes adjustable.

The most important thing to understand about an ARM (before you commit to closing on one) is what happens when the rate becomes adjustable. There are some different terms that you should familiarize yourself with. What these terms correlate to on the ARM you choose will describe what can happen to your payment after the ARM enters the adjustable rate period.

• Adjustment Frequency
• Index
• Margin
• First-time adjustment cap
• Subsequent adjustment cap
• Lifetime adjustment cap
• Floor

After the initial fixed rate period ends, your interest rate can begin to adjust. The frequency that it can adjust is based on the adjustment frequency of the ARM (also called adjustment period). It is common for ARMs to have rate adjustments every 6 months or 1 year from the initial adjustment date. For example, if you had a 5 year / 6 month ARM, your rate would be fixed for 5 years, and at the end of 5 years your rate would adjust. Moving forward from that point, every 6 months your rate would adjust. Sometimes ARMs adjust upwards and sometimes downwards.

How is my ARM rate calculated once it becomes adjustable?

When an ARM comes out of its fixed period, the new interest rate is calculated as follows (this is a bit of an oversimplification – keep reading):

INDEX + MARGIN = New Rate

What is an ARM index?

Every ARM has an associated index when you close on the loan. An index is a fluctuating measure of interest rates that generally reflect trends in the overall economy. You can usually find the value for a given index by doing a search on Google. Keep in mind that some ARMs use averages of an index. A common index we’re seeing more recently is the SOFR (Secured Overnight Financing Rate) 30 day average. The day your ARM goes to adjust they will use the corresponding index in the rate calculation.

What is the ARM margin?

The margin for an ARM is a fixed percentage that is added to the index to yield your fully indexed rate. Different ARMs have different margins. Historically, shorter term ARMs (3 year fixed or 5 year fixed) have lower margins than longer term ARMs (7 year fixed versus 10 year fixed).

When does my rate adjust?

Your rate on an ARM will adjust every time you get to the next adjustment period. If you have a 6-month adjustment period, your ARM will adjust every 6 months. If you have a 1-year adjustment period, your ARM will adjust every year on the anniversary of your first adjustment. This is after you get to the end of the initial fixed rate period on your ARM.

Is there any protection that prevents my rate from going higher?

The short answer is that there is not any protection against your rate going higher than the initial rate. There are however adjustment caps that prevent your rate from going above a certain point. There are three standard adjustment caps: First-time adjustment cap, subsequent adjustment cap, and the lifetime adjustment cap.

First-time adjustment cap

This is the maximum your rate can go up during the first adjustment to your ARM. Depending on the type of ARM you get, the first adjustment cap can vary significantly. If your starting rate was 4.5% and you have a first-time adjustment cap of 5%, your rate could go up to a maximum of 9.5% on the first adjustment (depending on the index + margin calculation we covered above on the change date). In that same example, if your first-time adjustment cap was 2%, your rate could go up to a maximum of 7.5%. So, the first-time adjustment cap is important to understand because it will govern the potential increase to your rate the first time it adjusts.

Subsequent adjustment cap

This is the maximum your rate can go up on every adjustment after the first adjustment – on every change date. It functions just like the first-time cap in that it limits the rate adjustment at every adjustment after the first one. Typically, this adjustment cap is lower than the first-time adjustment cap on longer term ARMs (read more below).

Lifetime Adjustment Cap

The lifetime adjustment cap is perhaps the most important of all the adjustment caps. This is the maximum the rate can go ever in the life of the loan. In other words, this is the worst-case scenario. Your rate can never go higher than the lifetime adjustment cap plus your original interest rate. For example, if your initial rate was 4.5% and your lifetime cap is 5%, your adjusted rate can never be higher than 9.5%.

Can my ARM rate go down?

Your ARM rate (once in the adjustable rate period) can go down as well. In the past we have seen ARMs come out of their fixed rate period and go down as a result of the index being extremely low. Below is an example:

Fixed Rate Before Adjustment: 4.5%

Interest Rate at Adjustment: .779% (INDEX) + 2.75% (MARGIN) = 3.529%

It is possible for your rate to go up as well as down during each adjustment period. The caps that we detailed above will typically apply to increases in rate as well as reductions in rate.

Can my rate go to zero?

Technically it could if the rules that govern your ARM’s caps allowed for it. This would be very uncommon. The lowest your rate can go is called the floor or floor rate. The most common floor rate to your ARM is the margin. The floor rate would be the lowest rate your ARM could drop to even if the calculation of INDEX + MARGIN equaled a number lower than the margin.

Getting into an Adjustable Rate Mortgage should be thoughtfully considered. The savings you experience upfront might not couple with the excess cost down the road if your ARM adjusts higher and your budget can’t accommodate it. There are no guarantees that you will be able to refinance your ARM to a lower rate after the fixed period.

That being said, as 30 year fixed interest rates rise, ARMs will reenter the mortgage market as an option to defray the cost of homeownership over the short term. Understanding how these loans work could save you thousands in interest if you pick an ARM that matches your timeline to own a home.

Read more about ARMs in the CFPB’s Consumer Handbook on Adjustable Rate Mortgages