What is an ARM Loan? (What You Should Know)

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. Read on to see if an ARM is the right option for you to achieve your dream of homeownership.

How do ARM loans work?

An adjustable-rate mortgage refers to any home loan that has an interest rate that can change over time. Whereas a fixed-rate mortgage locks in a rate for the loan’s 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:

1. 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.

2. 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 six months or once a year and continue for the life of the loan.

There are two important factors that will determine your interest rate during the adjustable period: an index and a margin. Together, they determine your mortgage payment:

• Index rate: A benchmark interest rate 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

ARM rate caps

Most ARMs have limits on how high an interest rate can rise to help protect you from dramatic rate increases. Rate caps help limit the risk of sudden, large increases due to rising rates. There are three 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.

Common types of ARM loans

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 six months or every year.

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 ARM options

Is a 7/1 ARM a good idea? Is a 5-year ARM a good idea? The answers to these questions depend on your unique situation and what best meets your needs. 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.

ARM pros and cons

As you decide if an ARM is right for your situation, it can be helpful to compare the pros and cons side by side. Here are the advantages and disadvantages of choosing an ARM loan for your homebuying endeavors.

ARM pros:

• Lower initial interest rates: ARMs typically offer lower introductory rates than fixed-rate mortgages, making early monthly payments more affordable.

• Potential savings: If you plan to move or refinance before the adjustment period begins, you could save significantly on interest.

• Rate caps offer protection: This limits how much your interest rate is allowed to increase over time.

• Falling rates can benefit you: If market rates drop, your ARM rate (and payment) could decrease as well—without refinancing.

ARM cons:

• Rate uncertainty: After the introductory period, your interest rate can rise, potentially leading to much higher monthly payments.
• Complex terms: ARMs often have complicated structures (such as 5/1, 7/1, rate caps, margins) that can confuse borrowers.
• Budgeting challenges: Fluctuating payments may make it more difficult to plan long-term household budgets.
• Refinancing risks: If interest rates rise or your credit profile weakens, refinancing out of an ARM could become difficult or costly.

How to apply for an ARM

Lenders may pre-qualify you during your initial meetings to help you determine how much home you can likely afford. The process varies, but usually involves you 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 discover a home you like and feel ready to submit an offer, they will work with you on pre-approval which requires more documentation and a hard credit check. While not official approval, it is a step in the right direction. However, 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.

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

Within three business days of receiving your application, your lender is required to provide a loan estimate. This three-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 approval 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 15 steps to buying a home.

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

Who should consider an ARM?

Every homebuyer’s financial situation and homebuying needs are different, and what works for others may not be right for you. To decide if an ARM is right for you, you need to consider your financial situation, current and projected market conditions, plus other factors, (like how long you plan on being in your home).

If you are stuck deciding between a fixed-rate mortgage or an adjustable-rate mortgage, here are some situations where an ARM may be the better option :

• You are choosing a jumbo loan: If you are financing a home that requires a jumbo loan, ARM rates can often be lower than those for 30-year fixed-rate mortgages, potentially saving you money.

• Interest rates are high or rising: When fixed rates are elevated, the lower introductory rates of ARMs can offer short-term relief and affordability.

• You plan to move within a few years: If you do not plan to stay in the home long-term—say, 3 to 10 years—an ARM can be a cost-effective option, especially if you sell or refinance before the rate adjusts.

• You are in a transitional phase: For those with known career moves ahead, such as military personnel or professionals expecting relocation, an ARM aligns well with a shorter timeline.

• You can handle potential rate increases: If your budget can absorb a possible rate hike after the introductory period, the initial savings of an ARM may still be worth it.

Is an ARM loan right for you?

There are a multitude of home loan options available, it is just about finding the one that works best your for homebuying journey. In the end, it is best to research your loan options and discuss them with a loan officer you trust.