Adjustable-Rate Mortgage (ARM): Definition, Benefits, and Risks

What Is an Adjustable-Rate Mortgage (ARM)?

An adjustable-rate mortgage (ARM) is a home loan whose interest rate can change at predetermined intervals. Unlike a fixed-rate mortgage, the ARM starts with a lower introductory rate, known as the teaser rate, then adjusts up or down based on an index such as the SOFR, COFI, or Treasury rate. Understanding its mechanics helps borrowers choose wisely.

How Does an ARM Work?

Every ARM has two key numbers, like 5/1 or 7/6. The first indicates the length, in years, of the fixed introductory period; the second shows how often the rate can change afterward. When that period ends, the rate resets by adding a margin to the chosen index, subject to periodic and lifetime caps that limit how high or low the rate can go.

Pros and Cons of an Adjustable-Rate Mortgage

Advantages

Because the initial rate is typically lower than comparable fixed loans, an ARM can help buyers qualify for a larger home or save cash during the early years. If market rates fall, the loan may adjust downward automatically, avoiding closing costs associated with refinancing.

Drawbacks

Rate uncertainty is the biggest risk. If the index rises sharply, monthly payments can climb, squeezing household budgets. Borrowers who plan to keep the property past the introductory period must be prepared for potential volatility, and those with tight finances could face payment shock that makes refinancing necessary at the wrong time.

Who Should Consider an ARM?

An ARM suits buyers who expect to relocate, trade up, or pay off the loan within the fixed period, as well as investors who intend to sell quickly. It can also appeal to disciplined homeowners confident they can refinance or absorb higher payments later.

Key Takeaways

Compare margin, caps, and adjustment frequency, not just the teaser rate. Calculate worst-case payments before signing, and maintain an emergency fund. When used strategically, an adjustable-rate mortgage can be a powerful financial tool; when misunderstood, it can become an expensive burden.