How an adjustable rate mortgage works
Every ARM has two phases. During the initial period the rate is fixed, just like a traditional mortgage. When that period ends, the rate begins to adjust on a set schedule, usually every six months or once a year. Each new rate is calculated by adding a fixed margin to a market index, such as the Secured Overnight Financing Rate. If the index rises, your rate can rise. If it falls, your rate can fall.
Caps protect you from big jumps
Every ARM includes three limits. Understanding them is the single most important part of choosing an ARM.
| Feature | What it limits | A common example |
|---|---|---|
| Initial adjustment cap | How much the rate can change the first time it adjusts | 2 percentage points |
| Periodic cap | How much it can change at each later adjustment | 1 percentage point |
| Lifetime cap | The most it can ever rise above the starting rate | 5 percentage points |
ARM or fixed rate?
| Feature | Adjustable rate | 30-year fixed |
|---|---|---|
| Starting rate | Usually lower | Usually higher |
| Payment certainty | Fixed only during the initial period | Fixed for the life of the loan |
| Best for | A 5 to 10 year plan | Staying put for the long haul |
| Main risk | Payment can rise after adjusting | Paying more if you move early |
When rates are rising
When interest rates are moving up, the gap between ARM and fixed rates often widens, which makes the ARM's starting discount more attractive. It also means future adjustments could be higher. That is why we always show you the payment at the first adjustment cap and at the lifetime cap, so you know your worst case before you sign.
An ARM may fit you if
- You expect to move, sell or refinance before the fixed period ends
- Your income is likely to grow over the next several years
- You want the lowest payment now and understand the adjustment rules
- You can comfortably afford the payment at the first adjustment cap
