How Adjustable Rate Mortgages (ARMs) Actually Work

Adjustable-rate mortgages, or ARMs, can be an attractive alternative to a traditional 30-year fixed mortgage, particularly when they offer a lower introductory rate. But to properly evaluate an ARM, you need to understand what happens when that initial fixed period ends.

An ARM is typically described with numbers such as 5/6, 7/6 or 10/6. The first number tells you how many years the initial interest rate is fixed. A 7/6 ARM, for example, has a fixed rate for the first seven years. After that, the rate can adjust every six months, which is what the “6” represents.

When the loan reaches its first adjustment, the lender doesn't simply choose a new rate. The rate is determined using two components: an index and a margin. The index is a market-based benchmark that can move up or down over time, while the margin is a fixed percentage established when the loan is originated. Add the two together and you get what is known as the fully indexed rate.

For example, suppose you have a 7/6 ARM with a 2.75% margin. Seven years from now, if the applicable index is 4.00%, the fully indexed rate would be 6.75%.

That doesn't necessarily mean your rate can immediately jump to 6.75%, however. ARMs also have rate caps, which limit how much the interest rate can change. You might see a cap structure written as 5/1/5. In this example, the rate could increase by no more than 5 percentage points at the first adjustment, no more than 1 percentage point at each subsequent adjustment, and no more than 5 percentage points above the original rate over the life of the loan.

So let's say you take out a 7/6 ARM today at 5.50% with 5/1/5 caps. The rate stays at 5.50% for seven years. At the first adjustment, the index is 4.00% and your margin is 2.75%, producing a fully indexed rate of 6.75%. Since that increase falls within the initial cap, your rate could adjust to 6.75%.

Six months later, imagine market rates have moved higher and the index plus margin would produce an 8.00% rate. Because the subsequent adjustment cap is 1%, your rate couldn't immediately jump from 6.75% to 8.00%. It would be limited to 7.75% for that adjustment. And because the loan began at 5.50% with a 5% lifetime cap, the rate could never exceed 10.50%, even if the underlying index moved significantly higher.

This is why the introductory rate isn't the only number to look at when comparing ARMs. The index, margin, caps and adjustment frequency determine how the loan will behave after the fixed period expires.

For the right borrower, that can make an ARM a useful option. Someone who expects to sell the property, refinance, or pay off a significant portion of the mortgage before the initial fixed period ends may be able to benefit from the lower introductory rate without ever reaching an adjustment.

The important thing is understanding the entire structure of the loan—not simply choosing the mortgage with the lowest rate today.

If you're considering an ARM, I can compare it side-by-side with a fixed-rate mortgage and show you both the potential.