Adjustable-Rate Mortgage (ARM)

An adjustable-rate mortgage (ARM), also called a variable-rate mortgage outside the United States, is a home loan whose interest rate changes periodically over the life of the loan, in contrast to a fixed-rate loan where the rate never moves for the entire term. The initial rate on an ARM is usually set below prevailing fixed rates, which is the main reason borrowers choose it, but the rate can rise, or fall, once the initial period ends and the loan begins to track the market.

The rate on an ARM is tied to a published reference benchmark, called the interest rate index, plus a fixed margin set by the lender at origination. As the index moves, the loan's rate resets at predetermined adjustment dates, and the new rate applies for the following adjustment period, continuing until the next reset.

An ARM trades a known, fixed cost for a cheaper starting price with an unknown future cost. It is a bit like a variable-price contract for electricity: the opening rate may look attractive, but the bill can move with the market later, and the borrower needs to be comfortable with that uncertainty before signing up.

Almost every ARM contract includes a ceiling, or cap, limiting how high the rate can rise at a single adjustment and over the life of the loan, along with a floor limiting how far it can fall. These limits exist precisely because an unlimited ARM would expose the borrower to open-ended payment risk if interest rates spiked sharply during the loan's term.

• A hybrid ARM, often written as 5/1 or 7/1, keeps the initial rate fixed for the first five or seven years before switching to annual adjustments.
• A fully amortized ARM sets each new payment at a level that will pay off the remaining balance by the loan's maturity, recalculated at every adjustment.
• A fixed-rate mortgage, by contrast, never adjusts and is usually preferred by borrowers who want payment certainty over the life of the loan regardless of market moves.

Borrowers who expect to sell or refinance before the initial fixed period ends, or who expect their income to rise, often accept an ARM's rate risk in exchange for a lower starting rate and payment. The risk is that if rates rise sharply by the time the first adjustment arrives, the new payment can be meaningfully higher than the borrower budgeted for, which is why regulators in most countries require clear disclosure of the maximum possible payment before a borrower signs a loan agreement.

A small subset of ARM products, sometimes called payment-option ARMs, allow a minimum payment lower than the interest actually accruing, which causes the unpaid interest to be added back to the principal balance, a phenomenon called negative amortization. These products became notorious during the 2007–2008 housing crisis and are far less common today, but borrowers should confirm an ARM fully amortizes rather than permitting this structure before signing.

Borrowers who no longer want to carry an ARM's rate risk, whether because of a changed financial situation or rising rate expectations, can generally refinance into a fixed-rate mortgage at any point, though doing so before the first adjustment date typically avoids paying any of the uncertainty the ARM was originally taken on to avoid.

The very low introductory rate sometimes advertised for an ARM, occasionally called a teaser rate, can make the loan look more attractive than it will be once the fully indexed rate applies after the first adjustment, which is why financial advisers encourage borrowers to compare loans using the likely future payment, not just the advertised opening rate.

Because the eventual cost of an ARM depends on unpredictable future interest rate movements, regulators typically require lenders to provide worst-case payment scenarios and an index-and-margin explanation well before closing, giving borrowers a clearer picture of the loan's true risk profile than the initial rate alone would suggest.

• Consumer Financial Protection Bureau