What Is an Adjustable-Rate Mortgage (ARM) and How Does It Work?

If you’re a home buyer on a tight budget, an adjustable-rate mortgage (ARM) might sound good. After all, ARMs have lower interest rates than fixed-rate mortgages—at first.

But after a few years, that low-interest dream turns into a high-interest nightmare. (It’s like when someone attractive catches your eye, then you realize they’re a jerk.)

An adjustable-rate mortgage is not good for you. Find out what ARMs are, how they work, and what’s wrong with them—plus a better way to buy a home!

What Is an Adjustable-Rate Mortgage?

If you’re wondering what an ARM loan is, it’s pretty simple. An adjustable-rate mortgage is a home loan where the lender can change your interest rate. Usually, that means your rate goes up. And up. And up. Which can cost you an arm and a leg—pun intended.

Why Are ARMs So Popular?

Lately, more people are taking out ARMs. In fact, 9% of recent home loan borrowers applied for an ARM.¹

That’s because at first glance, an ARM looks cheaper than a fixed-rate loan. It has a low interest rate and low monthly payment. What’s not to love? The trouble is, looks can be deceiving. That low rate goes up fast—leaving you with a monthly payment you can’t afford.

And when you know how ARMs actually work, you can see why they’re a bad idea.

How Does an Adjustable-Rate Mortgage Work?

An ARM loan has three basic parts:

• Initial interest rate – the interest rate your ARM starts with

• Introductory period – the time when your interest rate stays the same

• Adjustment period – the time when your interest rate can go up and down

So how do those work together? 

When you take out an ARM, the bank sets an initial interest rate. Usually, it’s about 1% lower than a conventional mortgage rate. In mid-April 2022, the average interest rate was 5.37% for a conventional loan, while adjustable mortgage rates were around 4.3%.²

That low rate stays locked in during the introductory period—anywhere from one to 10 years. Then the honeymoon’s over.

You’ve now entered the adjustment period. Now, the lender can change your interest rate—and your mortgage payment—every year. Or worse, every six months. And they’ll keep raising it until they hit the rate cap.

What’s the rate cap, you ask? Great question!

ARM Rate Caps

A rate cap is a limit on how much the lender can change your interest rate. Beware: The higher the rate cap, the higher your rate can go. The three main rate caps are:

• Periodic – limits how much the lender can raise or lower your rate during a single adjustment period

• Lifetime – limits how much the interest rate can change throughout all the adjustment periods combined

• Payment – limits how high your monthly mortgage payment can go

On top of those rate caps, some ARMs also limit how many times lenders can change rates over the life of the loan. For instance, they may be able to raise or lower the rate five times in a 30-year ARM.

Adjustable-Rate Mortgage Examples

There are different ARM options, and they all have numbers in their name. Those numbers represent the loan’s introductory period, adjustment period and rate caps. But honestly, they’re flat-out confusing to most people.

Dave Ramsey recommends one mortgage company. This one!

That’s because lenders want to confuse you. They want you to think an ARM is too complicated for you to understand, so you’ll do whatever they say. (What? Banks and mortgage lenders trying to trick you? Say it ain’t so!)

We can’t stand that! So we’re giving away their secrets and teaching you how to understand ARMs for yourself.

5/1 ARM With 2/1/5 Caps

Let’s imagine John and Julie got the most popular adjustable-rate mortgage, a 5/1 ARM. (Bad idea, y’all!) Here’s what that means for John and Julie:

ARM Name	What It Means
5/1 ARM	An ARM with a five-year introductory period, after which the rate can change once a year

Some similar loans are 3/1, 7/1, 10/1, 5/5 and 15/15 ARMs. In each case, the first number is the amount of years in the introductory period. The second number is the amount of years between rate changes. So with a 5/5 ARM, you’d have a five-year introductory period, with rate changes every five years after that.

Make sense? Great, you’re getting the hang of this!

Now, John and Julie still have some questions: How much can their lender increase their rate each year? How many times can the lender change their interest rate over the life of the loan?

That’s where those 2/1/5 rate caps come in. Take a look:

ARM Cap	What It Means
2/1/5	2% per-year rate change in the first adjustment period 1% rate change during any adjustment period after that 5% total adjustment above or below the initial rate

While the numbers we looked at a minute ago represent years, rate caps are all about percentages. Rate caps basically say how much the lender can change your rate at any given time.

Lenders want you to think those rate caps will protect you, but that’s not how it works. Look what happens to John and Julie’s 30-year ARM when they start at 4.3% interest:

Life of ARM Loan	Rate Change	Interest Rate
Years 1–5	None	4.3%
Year 6	2%	6.3%
Year 7	1%	7.3%
Year 8	1%	8.3%
Year 9	1%	9.3%
Years 10–30	None	9.3%

John and Julie’s interest rate more than doubled! That’s insane—especially when lenders issue fixed-rate mortgages around 5–6%. And since lenders rarely lower adjustable mortgage rates, John and Julie could get stuck paying a crazy rate for 20 years. Bad move!

5/6 ARM With 2/2/5 Caps

Jason also got a 30-year ARM with a 4.3% initial rate—but he chose a 5/6 ARM. Jason thought he’d have a five-year introductory period with adjustments every six years. Wrong!

ARM Name	What It Means
5/6 ARM	An ARM with a five-year introductory period, after which the rate can change every six months

Lenders changed the meaning of the second number. Sneaky, huh?  

The 5/6 isn’t the only ARM like this, either. With 2/28 and 3/27 ARMs, your rate also changes every six months. But lenders replaced the number six with the number of years in the adjustment period.  Why would they do that? To trick you into signing up for a bad deal. Don’t fall for it!

Unfortunately, our friend Jason already took the bait. But at least when it comes to his 2/2/5 rate caps, the meaning of those numbers stays the same. Take a look:

ARM Cap	What It Means
2/2/5	2% per-year rate change in the first adjustment period 2% rate change during any adjustment period after that 5% total adjustment above or below the initial rate

It doesn’t sound that bad, right? Sure, the rate can change by up to 2% in later adjustment periods, but it still can’t rise more than 5% above the initial rate.

But Jason’s about to learn that’s a big deal. Check out how fast his interest rate can fluctuate:

Life of Loan	Rate Change	Interest Rate
Years 1–5	None	4.3%
Year 5 1/2	2%	6.3%
Year 6	2%	8.3%
Year 6 1/2	1%	9.3%
Years 7–30	None	9.3%

You can see where things start to go haywire. Even though Jason has the same loan length, initial interest rate and first rate spike as John and Julie, his interest rate maxed out way sooner. So Jason will pay 9.3% interest for almost 24 years—thousands of dollars more interest than John and Julie will pay.

One More Adjustable Mortgage Rate Cap

Like we said earlier, some ARMs limit how many times lenders can raise or lower interest rates. That sounds smart at first. Limiting how many times the lender can change your rate gives you more stability, right?

But again, ARM lenders use this rate cap against you. They watch the market and make your final adjustment when rates are sky high. Then you’ll be stuck paying them super high interest for years. And there are no more adjustments, even if other people’s rates go back down.

At the end of the day, most ARM borrowers never know how much they’ll have to pay each month or how much their home will cost in the long run. Now that’s just silly!

It’s also why ARMs are bad news—and why mortgage lenders purposely make them so complicated! If they can keep you confused about rate caps, they can take more of your hard-earned money.

Do Rate Caps Really Work That Way?

To be fair, we’re using worst-case scenarios to make a point: ARMs can get you in a bad spot fast. More than likely, your lender won’t use the maximum rate change every time—but your rates will go up.

Unless the housing market goes crazy, they’ll probably bump your rate up in small amounts. They do that over time so you don’t notice your rate—and your monthly payment—creeping up. They may even lower your rate half a percent occasionally, so you feel like you’re getting a good deal.

But remember, lenders make money by charging you interest—even if that means you’re paying 8% interest on a ridiculous mortgage you can’t afford. So if you’re hoping they’ll lower your rate again, keep dreaming!

How Are Variable ARM Rates Determined?

Look closer and you'll see why an ARM’s initial rate is so low: The bank is hoping rates will rise in the general housing market, so they can charge you more.

But how do lenders determine each new rate?

Lenders set adjustable mortgage rates based on an index that shows how high or low interest rates are in the general housing market. Then they add a few percentage points, called a margin, to your rate.

Imagine the lender's index shows market rates around 5%, and they use a 2% margin. They'll lure you in with an initial rate below 5%. Then, when your introductory period ends, they'll raise your interest rate to 7%. Womp womp.

Your ARM paperwork will tell you which index the lender uses and how much their margin is. Some common indexes lenders use are the London Interbank Offered Rate (LIBOR), the prime rate, Fannie Mae, Freddie Mac, federal funds rate and treasury bill rates.

Bottom line? No matter which index your lender uses, you can count on one thing: They'll usually change your rate to benefit themselves—not you. The rate may be low for a little while, but in today’s housing market, all trends point up.

Types of Adjustable-Rate Mortgages

Now, lenders like to confuse you with all the different ARMs you can choose from. But when you know the types of ARMs, you can defend yourself from those fast-talking mortgage lenders.

Let's dig in.  

Conforming vs. Nonconforming ARMs

Every ARM loan is either conforming or nonconforming.

Conforming ARMs follow government rules, so private lenders can sell these loans to Fannie Mae or Freddie Mac. (These two big, government-backed agencies buy home loans as so-called investments.)

Nonconforming loans don’t follow those rules—or else they’re really big and risky (aka jumbo loans). Federal Housing Association (FHA) and U.S. Department of Veteran Affairs (VA) loans are also nonconforming, since other government agencies back them.

Hybrid ARMs

Hybrid ARMs are the most common adjustable-rate mortgages. (That’s why we used them in our examples earlier.) They have a fixed interest rate for part of the loan term and a variable rate the rest of the time.

Interest-Only ARMs

These suckers are a money-making scheme! With an interest-only ARM, you pay the interest during your introductory period . . . but the original loan balance just sits there. That’s like exercising and then eating a whole pizza. You’re not making any progress.

But it gets worse. After your introductory period, you’ll have to start making huge monthly payments on that principal because you didn't touch it the first few years of your loan. Oh, and now that you’re finally trying to pay off your house, the lender will want to slow you down and line their pockets. So expect those scum-buckets to raise your rates right about now!

Payment-Option ARMs

Payment-option ARMs let the borrower choose a custom payment plan. That may sound good, but beware: Lenders will let you make terrible choices here!

They’ll let you pick loans that last up to 40 years. Yes, 40! And they’ll let you set monthly payments so low, you can’t even cover the interest. Your mortgage will get bigger and bigger, until you wind up facing foreclosure.

ARMs vs. Fixed-Rate Mortgages

We’ve been pretty clear about why we don’t like adjustable-rate mortgages. But how do they really compare to a fixed-rate mortgage?

Let’s look at three loans so you can see for yourself: a 5/1 ARM, a 30-year fixed-rate mortgage, and a 15-year fixed-rate mortgage.

To keep things fair, each loan balance totals $200,000 after the down payment and has an average interest rate based on Freddie Mac’s April 2022 data. We also left out insurance, property taxes and other fees.

Loan Terms	30-Year 5/1 ARM	30-Year Fixed-Rate	15-Year Fixed-Rate
Type	5/1 ARM	Fixed-rate	Fixed-rate
Length	30 years	30 years	15 years
Initial Interest Rate	3.70%3	4.98%4	4.22%5
Rate Cap	12%	N/A	N/A
Initial Monthly Payment	$921	$1,071	$1,502
Maximum Monthly Payment	$1,303	N/A	N/A
Total Interest Paid	$205,734	$185,632	$70,274
Total Cost	$405,734	$385,632	$270,274

Okay, you can see ARMs start with the lowest monthly payment, but they cost the most long-term. And the monthly payment increases by hundreds of dollars. Why? Variable interest rates!

Mortgage lenders always raise those rates over time—and even if they don’t hit the rate cap, they’ll put the hurt on you. And all that interest adds up. In the end, a fixed-rate conventional loan is a smarter, cheaper choice. You’ll pay way more interest with an ARM—maybe even more than you originally owed on the house!

So if you take out an ARM, you’re betting against yourself and your long-term financial security. And 30-year fixed-rate mortgages aren’t much better.

Something similar happens with fixed-rate conventional mortgages. Historically, 30-year mortgages tend to have higher interest rates than 15-year mortgages. Those higher rates add up over time—costing you tens of thousands of dollars.

Your best bet is a 15-year fixed-rate mortgage. It’ll give you more control over your money and shift the risk of high interest rates back where it belongs—on the lender. They’re making the profit, so they should take on the risks.

And even though your monthly payment will be higher with a 15-year fixed-rate mortgage, you’ll save tens of thousands of dollars on interest and own your house decades sooner—no more monthly payments or obnoxious lenders. Score!

Is an Adjustable-Rate Mortgage Right For You?

Okay, we’re going to be brutally honest here: An ARM isn’t right for you—or anyone else.

And when you stop to think about it, ARMs make less sense now than ever before. Sure, that low initial rate may save you a few bucks a month in the beginning. But once the lender starts switching the rate on you, they’ll blow a hole in your budget. Then you’ll have to deal with that crazy high mortgage payment on top of fighting inflation and living expenses.

So why are so many people so eager to get themselves into a variable-rate home loan? Because they’re thinking about the short term. They’re not looking at the big picture when their rate hits double digits. Or when their monthly payment soars. Or when they can't sleep at night with that adjustable-rate mortgage looming over their head.

That’s why you should get a 15-year, fixed-rate mortgage instead. Locking in your interest rate gives you the stability to plan long term and saves you money if interest rates go up.

Avoid the ARM trap and talk to the mortgage experts at Churchill Mortgage. They’ll help you understand your home loan options so you can make the best decision for you and your family. We trust them so much, we'd send our own moms to them (and a lot of us have). That's why they're RamseyTrusted.