What Is An ARM Loan? What To Expect

An adjustable-rate mortgage (ARM), also called a variable-rate mortgage, can be a powerful way for you to take advantage of below-average interest rates—as long as you understand how to take advantage of ARM benefits.

ARMs are available for conventional, Veterans Affairs (VA), and Federal Housing Administration (FHA) loans. See how an ARM can become yours in 5 steps.

Step 1: Understand how ARMs work

As the name implies, an adjustable-rate mortgage has an interest rate that can change over time. Whereas a fixed-rate mortgage locks in a rate for the full term, an ARM’s rate will fluctuate with market conditions. That means your loan payment will go up or down throughout the life of your loan.

ARM loans have two distinct periods:

Fixed-rate period

ARMs begin with a set fixed-rate period, during which the interest rate will not change. The typical fixed-rate period can last from 3 to 10 years.

Adjustable-rate period

After the fixed-rate period ends, ARMs transition to an adjustable-rate period. This is when your mortgage payment will go up or down based on market conditions. Adjustments typically occur either once every 6 months or once a year and continue for the life of the loan.

Your interest rate during the adjustable period is determined by two factors: an index and a margin. Together, they determine your mortgage payment:

• Index rate. A benchmark that goes up and down based on the market; often tied to the Secured Overnight Financing Rate (SOFR)
• Margin rate. Set by your lender and fixed for the life of the loan

Interest rate caps

Most ARMs come with caps to protect you from dramatic rate increases. They help to limit your risk of sudden, large payment increases due to rising rates. There are 3 main caps that may be available:

• Initial Adjustment Cap. The maximum a rate can increase when transitioning from the fixed-rate period to the adjustable-rate period.
• Subsequent Adjustment Cap. The maximum a rate can increase after each adjustment period
• Lifetime Adjustment Cap. The maximum a rate can increase above the initial fixed rate for the life of the loan.

Step 2: Compare different ARM terms

Typically, ARMs are available in options where the fixed rate is set for 3, 5, 7, or 10 years. Once the fixed period ends and the adjustable period begins, the rate is recalculated either every 6 months or every year.

ARM term examples

Here are common types of ARMs and what their names mean:

• 3/1 ARM: Fixed rate for 3 years; then the rate adjusts every year
• 5/1 ARM: Fixed rate for 5 years; then the rate adjusts every year
• 5/6m ARM: Fixed rate for 5 years; then the rate adjusts every 6 months
• 7/1 ARM: Fixed rate for 7 years; then the rate adjusts every year
• 10/6m ARM: Fixed rate for 10 years; then the rate adjusts every 6 months

Comparing options

Is a 7/1 ARM a good idea? Is a 5-year ARM a good idea? These are simple questions with not-so-straightforward answers. When comparing loan options, you will not only want to consider the fixed-rate and adjustment periods, but the term length, margin, and caps. That is why you want an experienced lender to walk you through your options and help you decide.

Step 3: Some ARM lenders are better than others

There are many factors to consider when choosing a mortgage lender. Rates, while important, are just the start. The level of service you receive can be affected by their fees, community commitment, and whether they are a for-profit or not-for-profit organization.

Questions to ask your lender

The Consumer Financial Protection Bureau (CFPB) suggests asking the following ARM questions before committing to a lender:

• When and how often will the interest rate be adjusted?
• What is the index and margin on the loan?
• What are the rate caps on the loan?
• Will the payment be calculated at the same time as the interest rate?
• Does the loan have a floor rate?
• Does the loan have a prepayment penalty?

Getting prequalified and preapproved

Lenders may prequalify you during your initial meetings to help you determine how much home you can likely afford. The process varies, but usually involves your sharing some preliminary income details. The lender then completes a soft credit check, which is a type of credit check that does not affect your credit score, to make that initial estimate.

Once you find a property and are ready to make an offer, they will work with you on preapproval, which requires more documentation and a hard credit check. While not official approval, it is a step in the right direction.

Step 4: Apply for an ARM

An accepted offer means it is time to move forward. Your lender will request all documentation necessary to determine if you qualify for the loan.

ARM qualifications

Requirements vary greatly depending on your situation, your lender, and the type of loan you are applying for. Generally, you must:

• Meet a minimum credit score requirement
• Have an acceptable down payment
• Provide proof of income and work history
• Show details on current debts

Loan estimate

Within 3 business days of receiving your application, your lender is required to provide a loan estimate. This 3-page document details important figures including your anticipated down payment, interest rate, monthly payment, and total closing costs. Once you review this document, you may decide to move forward, or you may consider comparing options between lenders to decide what is best for you.

Upon receiving the green light to move forward, your lender will begin mortgage underwriting. You will then be able to schedule a property inspection, if necessary; an appraisal of the property will also be scheduled separately. For more details about this process, explore the 12 steps to buying a home.

If everything goes through, you will set up a meeting to sign paperwork and pay closing costs.

Step 5: Minimize risk

As you have learned, ARMs come with risk. You will likely have a below-average interest rate to start, but there is no guarantee it will last after the fixed-rate period ends. That means there is no security of a consistent rate and mortgage payment. If rates increase, your payment will increase as well.

That is why it is imperative to have a plan. Many ARM borrowers monitor the rate environment and choose one of the following before their fixed-rate period ends:

• Refinance to a fixed rate
• Sell the property
• Accept the fluctuations and reevaluate before the next adjustment

When in doubt, talk to your mortgage lender. Their expertise in this industry can help you weigh your options.