What is an Adjustable-Rate Mortgage?

When shopping for a home loan, one of the most important decisions you'll make is choosing between a fixed-rate mortgage and an adjustable-rate mortgage (ARM). While fixed-rate loans offer stability, ARMs can provide flexibility and potential savings—especially in the early years of homeownership.

Let's break down what adjustable-rate mortgages are, how they work, and whether they might be the right fit for your financial goals.

What Is an Adjustable-Rate Mortgage?

An adjustable-rate mortgage (ARM) is a type of home loan where the interest rate changes periodically based on market conditions. Unlike a fixed-rate mortgage, which locks in the same interest rate for the life of the loan, an ARM starts with a lower introductory rate that adjusts after a set period.

This initial period (often 5, 7, or 10 years) is known as the fixed-rate period, during which your interest rate and monthly payments remain stable. After that, the rate adjusts at regular intervals (usually annually), based on a benchmark index like the secured overnight financing rate (SOFR) or treasury rates, plus a lender-defined margin.

How Do ARMs Work?

ARMs are typically described using two numbers, such as 5/1 ARM or 7/6 ARM. Here’s what those numbers mean:

• First number: The length of the initial fixed-rate period (e.g., 5 years).
• Second number: How often the rate adjusts after the fixed period (e.g., every 1 year or every 6 months).

For example, let’s take a 5/1 ARM. There’s a fixed interest rate for the first 5 years. After that, the rate adjusts once per year for the remaining loan term.

Key Features of Adjustable-Rate Mortgages

1. Initial Lower Interest Rate
ARMs often start with a lower interest rate than fixed-rate mortgages, which can result in significant savings during the first few years.

2. Rate Caps
To protect borrowers from extreme rate hikes, ARMs include rate caps:

• Initial cap. How much the rate can increase after the fixed period.
• Periodic cap. Limits how much the rate can change during each adjustment.
• Lifetime cap. Limits the total increase over the life of the loan.

3. Index and Margin
The adjustable rate is calculated by adding a margin (set by the lender) to an index (a market-based rate). For example, if the index is 3% and the margin is 2.25%, your new rate would be 5.25%.

Pros and Cons of Adjustable-Rate Mortgages

Pros

Lower initial payments. Great for short-term homeowners or those expecting income growth.

Potential savings. If interest rates fall after the fixed-rate period, your payments could decrease.

Flexibility. Ideal for buyers who plan to refinance or sell before the adjustment period.

Cons

Uncertainty. Payments can rise significantly after the fixed period.

Complexity. Understanding caps, margins, and indexes can be confusing.

Risk. If rates rise sharply, your monthly budget could be strained.

Who Should Consider an ARM?

ARMs can be a smart choice for certain borrowers, including:

• First-time homebuyers who plan to move or upgrade within a few years.
• Professionals who are expecting a significant increase in income.
• Investors looking for short-term financing on rental properties.
• Homeowners who plan to refinance before the rate adjusts.

If you’re confident you won’t stay in the home long-term, the lower initial rate can offer meaningful savings.

Tips for Choosing the Right ARM

Understand the terms. Know your fixed-rate period, adjustment frequency, and rate caps.

Compare lenders. Margins and caps vary, so shop around.

Use mortgage calculators. Estimate future payments based on possible rate increases.

Plan for the future. Have a strategy in place for when the rate adjusts whether it’s refinancing, selling, or budgeting for higher payments.

Final Thoughts

Adjustable-rate mortgages offer a compelling alternative to fixed-rate loans, especially in a high-interest environment or for buyers with short-term plans. While they come with risks, understanding how ARMs work and how they fit into your financial strategy can help you make a confident, informed decision.

Before committing to any mortgage, speak with a trusted lender to explore your options and ensure the loan aligns with your long-term goals.

Find the Right Mortgage Loan with Peak

At Peak Credit Union, we’re committed to helping you get into the home of your dreams. The home loan process can be complicated, but you’ll have someone to guide you every step of the way. Our team of home loan experts will work with you to find the best home loan situation for your needs, whether you want a fixed-rate or adjustable-rate loan. For more information, visit our home loans page.

Or apply for a loan today online, by calling (800) 258-3115, or visiting your local Peak branch.