An adjustable-rate mortgage, or ARM, starts with a rate that holds steady for a set number of years and then moves with the market on a schedule written into your note. Four parts, all spelled out before you sign, decide what happens after the opening years.
The four parts of every ARM
- Initial fixed period. The years the starting rate can't move. A 5/1 ARM is fixed for five years and then adjusts once a year, while a 5/6 adjusts every six months after year five.
- Index. A published interest rate the loan follows, such as the Secured Overnight Financing Rate (SOFR) or the one-year Treasury rate. The lender names the index when you apply, and it stays with the loan.
- Margin. A set number of percentage points added to the index. It's written into the loan agreement and never changes. Index plus margin is called the fully indexed rate.
- Caps. Limits on each move. The CFPB lists three: an initial adjustment cap for the first reset (commonly 2 or 5 points), a subsequent cap for each reset after that (commonly 1 or 2 points), and a lifetime cap over the starting rate (most commonly 5 points). Lenders often write them as three numbers, such as 2/1/5.
How FHA, VA and Conventional handle ARMs
FHA insures 1, 3, 5, 7 and 10-year ARMs. The 1 and 3-year versions can rise 1 point a year and 5 points over the life of the loan. A 5-year FHA ARM uses either that 1 and 5 structure or 2 points a year and 6 over the life. The 7 and 10-year versions allow 2 points a year and 6 over the life. VA guarantees hybrid ARMs as well, while USDA guaranteed loans are 30-year fixed only.
Conventional ARMs follow Fannie Mae's qualifying rules. With a fixed period of five years or less, the lender qualifies you at the higher of two rates: the starting rate plus the first-reset cap, or the fully indexed rate. With a 7 or 10-year fixed period, qualifying generally uses the starting rate itself.
A 5/1 ARM through its first reset
Take a $300,000 loan at a 5.75% starting rate on a 30-year schedule, with a 2.75-point margin and 2/1/5 caps. The index values below are sample numbers to show the math.
| Stage | Rate | Monthly principal and interest |
|---|---|---|
| Years 1 to 5 | 5.75% | $1,750.72 |
| Balance after 60 payments | $278,286.56 | |
| Year 6, index at 2.50% (2.50 + 2.75) | 5.25% | $1,667.63 |
| Year 6, index at 3.75% (3.75 + 2.75) | 6.50% | $1,879.01 |
| Year 6 at the 2-point first-reset cap | 7.75% | $2,101.98 |
Each year-6 payment spreads the balance over the 300 months that remain. With the index at 2.50%, the payment drops $83.09 a month. The 2-point initial cap keeps the first reset at or below 7.75%, and the 5-point lifetime cap sets the ceiling for the whole loan at 10.75%, so the worst case is known on the day you sign.
Using an ARM well
An ARM works best with a plan for the reset date: a sale, a refinance, or income that will have grown by then. A buyer who expects to move up to a bigger home within seven years often picks a 7-year ARM so the fixed period covers that whole stretch. Before you lock, get the index, the margin and all three caps in writing. Your Loan Estimate also shows the highest the payment can reach and the year it could get there.
Put the starting payment and the capped payment side by side in the mortgage payment calculator. To price a 5, 7 or 10-year ARM against a 30-year fixed on the same home, call AAA Capital Funding at 888-601-8344.