What is an Adjustable-Rate Mortgage (ARM)?
An Adjustable-Rate Mortgage (ARM) is a type of home loan where the interest rate periodically changes based on the broader financial market. Unlike a fixed-rate mortgage where your payment stays exactly the same for 30 years, an ARM payment can go up or down over time.
How Does an ARM Work?
Most ARMs are structured as "hybrid" loans. This means they start with a fixed interest rate for a few years, and then switch to an adjustable rate for the remainder of the loan term. The CFPB ARM explainer details how adjustment caps work and what borrowers should ask lenders before choosing an adjustable-rate product.
You will usually see ARMs advertised with two numbers, such as 5/1 or 7/1.
- The First Number: Represents how many years the introductory fixed rate lasts. In a 5/1 ARM, your rate is locked for the first 5 years.
- The Second Number: Represents how often the rate adjusts after the introductory period ends. In a 5/1 ARM, the rate will adjust 1 time every year after the initial 5 years are up.
What are Rate Caps?
To prevent your monthly payment from instantly skyrocketing, ARMs come with built-in "caps" that limit how much the interest rate can increase. A common cap structure is 2/2/5, which means:
- Initial Cap (2%): The rate cannot increase by more than 2% at the very first adjustment.
- Periodic Cap (2%): The rate cannot increase by more than 2% during any subsequent yearly adjustment.
- Lifetime Cap (5%): The rate can never increase more than 5% above the original introductory rate over the life of the loan.
