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How Do Adjustable Rate Mortgages Work?

How Do Adjustable Rate Mortgages Work?

June 14, 2022
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If you're reading this, it's too late ... to buy a home.

Or at least, that's how you've been feeling in recent months as you've carried on a fruitless home search. Interest rates rising 2% or 3% in a matter of months, pricing you out of the homes that you could afford when you started looking. People bidding tens of thousands of dollars over asking price, causing you to lose out on the houses you COULD afford. And news that the Fed is considering increasing interest rates two or three additional times before the end of the year. 

All of these events have caused some to exit the home-buying market completely. For others, it has led them to search for alternative, non-traditional ways of financing their future homes so that they can still afford to be owners. This search has brought to the forefront a type of home loan that, following the 2008 housing crisis, had been villainized, and rightfully so. But desperate times call for desperate measures, which is why we find ourselves talking yet again about ... Adjustable Rate Mortgages, or ARMs.

ARM loans are a special type of financing, where homeowners can pay a fixed rate on their loan for a short period of time before the lender is able to adjust their rates to reflect current market conditions.

ARM loans are rising in popularity because the rates offered by these loans can be significantly lower than rates for a fixed-rate, 30 year loan. The potential rate increases for these loans represent a potentially huge risk to homeowners securing them so they can benefit from the temporary savings. But as interest rates and home prices skyrocket, borrowers are flocking to them in droves, understandably kicking the can down the road and hoping that they won't have to pay the piper (a lot of metaphors in one sentence, but you get the point). 

I want to make sure you not only understand the pros and cons of ARM loans - because there ARE pros - but also the terminology. ARM loans have some funky language. You might have a 6/1 ARM at 4% with 3/3/5 caps, for a 3/6 ARM at 5% with 2/2/4 caps. And to a lay person, that is gibberish.

So let's dig into how ARMs work, the pros and cons, and whether or not they're a potential solution for you.


Unlike fixed rate mortgages, adjustable-rate mortgages have the ability to change their rate throughout the course of the loan. They set these rates according to certain economic factors and, most importantly, the interest rate of their preferable index.

In mortgage terms, an index is an interest rate lenders rely on to determine what they will charge to customers.

For ARM loans, common indices on which lenders base rates would be the one, three or five year treasury yield. There are also lenders who will use the LIBOR, or the COFI as benchmarks for their ARM rates.

Index + Margin
After determining the index used to track rates, lenders also establish a margin for ARM loans that act as a buffer for their profitability in the event of rising rates.
As an example, a lender might state an Index + Margin of COFI + 2.5%, meaning if the COFI rate is 4.5%, the added buffer will lead to a borrower paying an Initial Interest Rate of 7% (the stated Index + Margin).

For the remainder of this post, we'll use the terms above - a COFI+2.5% Index+Margin with an Initial Interest Rate of 7% -  as the example from which we'll build our knowledge base. 

Here is an example of how these terms might be listed in a quote given by a lender:

Minimum/Maximum Interest Rate

Remember that ARM stands for ADJUSTABLE Rate Mortgage. The stated Min/Max Rates list how high or low the loan rate can be adjusted. Let's assume a stated Min/Max rate of 2%/12%, meaning throughout the course of the loan, the maximum increase or decrease from our Initial Interest Rate will be 5%. This maximum increase will come into play when we discuss Rate Caps.

Fixed Period and Change Frequency

The Fixed Period and Change Frequency are one of the first times you'll see the confusing terms most people associate with ARM loans. These numbers are typically expressed as X/X, with the first number stating the length of time lenders will pay a fixed rate on their loan, and the second number and expression of how frequently the rate can change after the Fixed Period.

Going back to our example, a 5/1 ARM would mean a borrower would have a fixed rate for the first five years of the loan, after which there rate can change no more frequently than once per year.

It's important to note that if viewing another example of a 5/6 ARM, the second digit in this case doesn't mean a fixed rate for five years and changes no more frequently than once every six years, but that the rate can change once every 6 months.

Rate Caps

Rate caps for adjustable-rate mortgages are designed to give the consumer a quick idea of the limits of any potential changes to their mortgage rate.

Rate caps are typically expressed in the following format: X/X/X, or using real numbers, 3/2/5.

We'll go back to our initial example, a 5/1 ARM at 5%, using the caps 3/2/5, to explain what each number in the sequence would mean.

  • First number: the largest interest increase or decrease allowed in the first adjustment following the fixed period. In our example, 3% is the largest swing, up or down, that you can see in your mortgage following our fixed period of five years. This would mean in Year Six, our mortgage rate can climb no higher than 8% and fall no lower than 2%. 

  • Second number: the largest increase or decrease allowable after the first adjustment, which in our example would be Year Seven. Let's assume that in the first adjustment after the fixed period, our mortgage rate increased to 7%. The second cap, 2%, would restrict any increases or decreases to a range of 5% to 9% (the 7% rate from Year 6 plus or minus the allowable 2% cap).

  • Third number: the largest increase or decrease allowable throughout the entirety of the loan. This number is the ceiling and floor for interest rates that should also be stated in the loan estimate provided by your lender, as well as the closing disclosure documents you will be provided prior to closing.

Should I Use an ARM?

  • So should you use an ARM? It depends. There are people who can greatly benefit from an ARM in the short-term, and even some who are a potential fit beyond the length of the Fixed Period. 

    In my experience, there are a few boxes you need to check before signing up for an ARM:
  • You're not moving into your dream home ...: in most cases, I would only recommend an ARM to a person or family fairly confident they'll be moving before the fixed period expires. For most people, the upper range of rates that an ARM could reach will be cost-prohibitive. It's extremely important you ask for a payment quote at the upper-end of this range. If you know you can't afford it and still pursue the ARM, a plan needs to be in place to move prior to the end of the fixed period if interest rates have risen.

  • ... but you are moving into an expensive home: this suggestion is all about economies of scale. The more expensive your home, the bigger difference a change in interest rates will mean for your payment. The lower your home value, the Initial Interest Rate savings offered by an ARM becomes less impactful. As an example, the difference between a 4% and a 5% mortgage for a $600,000 home loan is $357/month; significant savings for a high income-earner looking for a starter home in a high-priced area. Conversely, the savings on a 4% loan for $250,000 and a 5% loan for the same amount is $148/month. While any savings is significant, this amount may not be significant enough to take on the risk of an increasing rate for an individual or family buying a home they plan to live in long-term. They might be better off pursuing a fixed rate mortgage at a higher initial cost, in exchange for the certainty of knowing their rate will not change.

  • You're making a substantial down payment: this is all about home equity. There are those who secure ARM loans because the lower rate makes their payment affordable based on their current pay. As their income rises and they get equity in their home, their plan may be to refinance their home at a fixed rate. The problem with this plan is that in order to refinance, most lenders will require you to have at least 20% equity in your home, meaning you owe no more than 80% of your home's appraised value. The risk of making a low down payment on an ARM is that you have no established much equity in the home at the start of the loan, meaning you are placing yourself at the mercy of interest rates and the overall home market. If interest rates increase and home values decline, you may find yourself underwater in your home, meaning you owe more on the home than it's worth. Underwater mortgages cannot be refinanced, meaning if you stay in the house after the fixed period and home values have risen significantly, you may be stuck with the rate change or forced to sell a house for less than you owe on it (meaning you would still owe the bank after the transaction, which is known as a short sale).

  • You have the potential to refinance to a better rate: if the last recommendation is about equity, this one is about equity AND your finances. In an ideal world, those using an ARM for a long-term home would refinance to a fixed rate as quickly as possible. This strategy not only requires the home equity we just covered, but also an applicant with strong enough credit and a low enough debt to income ratio to qualify for the best rates. If a hopeful applicant plans to refinance and knows that these financial indicators aren't in tip-top shape, they should do whatever possible to improve them prior to refinancing. Doing so might be the difference between securing a rate that offers them a reasonable fixed payment for the entirety of their loan, or being approved for a rate so high that the loan payment isn't sustainable. 

  • The cap rate payment fits your budget: and finally, this recommendation is about your future income. When it comes to finances, I am a 'hope for the best, prepare for the worst' type of person. And even if you're not like that with most things, you MUST be when pursuing an ARM loan. You cannot assume you'll be able to sell the home for more than it's worth before the fixed period ends, or that you'll be able to refinance to a reasonable fixed rate. You must consider the possibility that neither option will be available, and that interest rates may rise significantly (as they are now). Should these events occur and you're stuck at the upper ranges of your loan's interest rate possibilities, you need to ensure the payment will fit in your budget. For most people, I would say this is unlikely. I say that because if they could afford a significantly higher payment, they likely would have opted for a traditional, fixed-rate loan at the start of the process. There are, however, certain professionals in industries where there is a defined path to a substantially higher income. An example would include medical residents, who may buy a home on a resident's pay but are poised for a significant income increase after training. Others might be an associate professor on a tenure track, or a therapist buying a home prior to licensure. Even a professional with student loans that will be paid off by the time the fixed period of their ARM expires can be more confident in pursuing these types of loans in spite of the potential payment increase. If you're NOT one of these professionals due for a significant increase in pay or decrease in expenses, an ARM may be a short-term solution that leads to a long-term problem in the event of a significant rate increase.

That's It!

We will probably continue to see an increase in the use of ARM loans, and maybe it's an option that will pop up in your home search as well. I hope this post gave you a better idea of how these loans work, as well as their pros and cons. And lastly, best of luck to you as you look for the home of your dreams!