Adjustable-Rate Mortgage (ARM)

ARM Structure

ARMs are described using two numbers that define their structure. A 5/1 ARM, for example, has a fixed rate for the first , then adjusts once per year for the remaining term. Common ARM configurations include 3/1, 5/1, 7/1, and 10/1. The initial fixed period offers a rate that is typically lower than comparable fixed-rate mortgages, which is the primary reason borrowers choose ARMs.

How Rate Adjustments Work

After the initial period, the rate is recalculated based on:

• Index: a benchmark rate such as the Secured Overnight Financing Rate (SOFR), which replaced LIBOR for most new ARMs
• Margin: a fixed percentage added to the index (typically ), set at origination and unchanged for the life of the loan

The new rate equals the current index value plus the margin. ARMs include rate caps that limit how much the rate can change:

• Initial adjustment cap: limits the first adjustment (commonly )
• Periodic cap: limits each subsequent adjustment (commonly )
• Lifetime cap: limits the total increase over the initial rate (commonly )

A common cap structure is 2/2/5, meaning the rate cannot increase more than 2% at the first adjustment, 2% at any subsequent adjustment, or 5% over the life of the loan.

Risk and Suitability

ARMs carry the risk of payment increases that can be substantial. However, they may be appropriate for borrowers who plan to sell or refinance before the first adjustment, or who expect their income to increase. Borrowers must qualify at a rate above the initial rate to ensure they can handle potential increases.