At a glance
- Rate
- Fixed, then adjustable
- Index plus margin after the initial period
- Protection
- Rate caps
- Initial, periodic and lifetime
- Programs
- Conventional, FHA, VA, jumbo
Educational overview, not a loan offer. Requirements vary by lender and borrower.
Overview
An adjustable-rate mortgage (ARM) starts with a fixed interest rate for an initial period, commonly several years. After that, the rate adjusts at set intervals based on a published index plus a margin.
Caps limit how much the rate can change at the first adjustment, at each later adjustment and over the life of the loan. ARMs are available in conventional, government and jumbo programs.
How an adjustable-rate mortgage works
An ARM has two phases. During the initial period, the rate is fixed. After that, on each change date the rate resets to the loan's index plus its margin, rounded as the note describes and limited by the caps. The index is a published market rate that moves over time; the margin is a fixed spread set when you take the loan.
Each reset also recalculates the payment so the remaining balance is repaid by the end of the loan. ARMs sold to Fannie Mae must be fully amortizing, so the balance doesn't grow. The new rate uses an index value from shortly before the change date, which is why notices go out in advance.
The terms to know:
- Initial period: how long the starting rate lasts
- Adjustment period: how often the rate can change afterward
- Index: the market rate the loan follows, such as the 30-day average of SOFR
- Margin: the fixed spread added to the index
- Caps: limits on each change and over the life of the loan
See also
Who an ARM can fit
An ARM is a choice about timing and flexibility more than about rates alone. It tends to make sense when the plan for the home has a clear horizon, or when the borrower could absorb a higher payment if plans change.
- A buyer on a work assignment who expects to relocate before the first adjustment
- A household expecting a substantial income increase, such as a physician finishing training, that can still handle the payment the lender must use to qualify them today
- A borrower with a large balance who has the savings to manage future changes and wants to compare fixed and adjustable pricing
- A homeowner planning to pay the loan down sharply, for example after selling another property
Where ARMs are available and what limits them
ARMs exist in most loan families. Fannie Mae and Freddie Mac buy ARMs that follow their standard plans, FHA insures ARMs, VA backs ARMs and hybrid ARMs with its guaranty under federal law, and jumbo and Non-QM lenders offer their own. Each sets its own rules on the index, caps and margin; Fannie Mae, for example, requires the 30-day average of SOFR and caps the margin it will accept.
Some programs restrict ARMs. Freddie Mac's HomeOne is fixed-rate only, and Freddie Mac doesn't buy super conforming ARMs with shorter initial periods. HomeReady and Home Possible allow certain ARM plans, and FHA and VA set their own rules on ARM features such as the index and caps.
Credit standards on an adjustable-rate loan
Credit standards for an ARM follow the program it belongs to, with a few ARM-specific twists. Fannie Mae's manual underwriting requires a higher minimum score for ARMs than for fixed-rate loans, and Fannie Mae applies an ARM-specific price adjustment to certain loans on top of its other adjustments. Jumbo and Non-QM ARMs follow each investor's score tiers.
Because the qualifying payment on a short fixed period can be higher than the starting payment, a borrower near the debt-to-income limit may find that a lower starting rate, when an ARM has one, doesn't translate into a larger approved amount. Your loan officer can run both versions to show the difference.
Equity rules when a program allows less on an ARM
An ARM doesn't change the basic down payment rules of the program it sits in, but some programs allow less financing on an ARM than on a fixed-rate loan. Fannie Mae's highest purchase financing tier is fixed-rate only, and Home Possible allows less financing on ARMs than on its fixed-rate version.
Equity also matters later. If the plan is to refinance before the first adjustment, the equity you have at that point, along with your credit and income, decides your options, and a drop in home value can make refinancing harder just when you want it.
How lenders test affordability on an ARM
Lenders must look past the introductory rate when they test whether you can afford an ARM. Under the general ability-to-repay rule, the payment is figured at the higher of the starting rate and the fully indexed rate, meaning the index plus the margin. For a qualified mortgage, the test uses the maximum rate the loan permits during its first five years of payments.
Agency rules add a cushion for ARMs with shorter fixed periods. Depending on the length of the fixed period, Fannie Mae qualifies the borrower at the highest rate possible early in the loan or at the fully indexed rate when that is higher. ARMs with longer fixed periods are generally qualified at the note rate unless the loan is higher-priced. The result: a short fixed period can reduce the loan amount you're eligible for, even when it starts lower.
Which homes and occupancy types allow an ARM
Fannie Mae's ARM plans can be used for principal residences, second homes and investment properties under its standard rules, and jumbo and Non-QM investor programs offer ARMs as well. Some combinations are limited: Fannie Mae permits temporary buydowns on ARMs only for principal residences and second homes, and only on plans with longer initial periods.
Business-purpose investor loans fall outside the consumer rule that bars prepayment penalties on ARMs, so an investor ARM's note may include one. The property type rarely changes how the index and caps work, but it does affect pricing and how much financing is available.
When an ARM works as a planning tool
Those features make an ARM a planning tool: it can suit a borrower whose timeline is clear and whose budget can handle a reset.
- The starting rate can be lower than a comparable fixed rate, though not always
- Caps limit how far the rate can move at each change and over the life of the loan
- If the index falls, the rate can fall at an adjustment, within the caps
- Fannie Mae says its ARMs are usually assumable, though some plans restrict it
- A consumer ARM secured by your home can't carry a prepayment penalty under federal rules
See also
Payment shock and other ARM risks
The central risk is payment shock. Once the fixed period ends, the payment can rise substantially and can keep rising at later changes until it reaches the lifetime cap. The CFPB cautions that the principal and interest payment on an ARM can climb sharply after the introductory period. Planning to sell or refinance before the first change is a strategy, not a sure thing: home values, income, credit and market rates at that time decide whether a refinance is possible.
ARMs are also harder to compare. Two loans with the same starting rate can have different indexes, margins, caps, floors and adjustment schedules, and those details decide what happens later. Refinancing out of an ARM also means new closing costs.
See also
Talk it through with Ruben
Compared with a temporary buydown, interest-only and fixed-rate loans
A feature comparison only. Not every lender offers all of these options; ask your loan officer which ones the lender offers and to show the figures for each.
Scroll sideways
| Feature | ARM | Temporary buydown | Interest-only | Conventional fixed rate |
|---|---|---|---|---|
| Can the rate rise after closing? | Yes, after the fixed period | Note rate is fixed; payment steps up as the subsidy ends | Depends on the loan | No |
| What lowers early payments | Introductory rate | Prepaid subsidy account | No principal during the interest-only period | Nothing |
| Pays down principal from the start | Yes | Yes | No | Yes |
| Can be a qualified mortgage | Yes, if requirements are met | Yes, if requirements are met | No | Yes, if requirements are met |
ARM scenarios: a job assignment, comparing caps, an adjustment notice
Illustrations only; outcomes depend on the loan terms and the market at each change date.
- A family relocating for a fixed-length job assignment picks an ARM whose fixed period outlasts the assignment, but first checks that the payment after the first change would still be manageable if they stay.
- A borrower compares two ARMs with the same starting rate. One has a higher margin and a lifetime cap that allows a larger increase, and the AIR tables on the two Loan Estimates make the difference visible.
- A homeowner receives the advance notice before the first adjustment, uses the months before the new payment to request refinance quotes, and decides based on equity, credit and costs at that point.
Disclosures and what to expect
Because an ARM's future payments are uncertain, federal rules require extra disclosures. For an ARM secured by your principal home, the lender generally must give you the CFPB's Consumer Handbook on Adjustable-Rate Mortgages and a program disclosure when you're given an application or before you pay a nonrefundable fee. The program disclosure explains the index, how the rate and payment are figured and how often they can change.
Your Loan Estimate then includes an Adjustable Interest Rate (AIR) table showing the index and margin, the initial rate, the minimum and maximum rates and how often the rate changes, and the Projected Payments table shows how the payment could move. After closing, the servicer must send notices before the first payment at a new rate and before later payment changes.
Misconceptions about ARM caps, the lifetime cap and starting discounts
Several common beliefs about how ARMs adjust and repay don't match how these loans work.
- Myth: caps keep the payment close to the original. Reality: caps limit rate changes, but even capped changes can raise the payment a great deal.
- Myth: the lifetime cap works in both directions. Reality: for Fannie Mae ARMs it limits increases only; how far the rate can fall depends on the per-change caps and the floor.
- Myth: a deep starting discount carries forward. Reality: future rates come from the index plus the margin; an introductory discount doesn't change the margin.
- Myth: an ARM is the same as an interest-only loan. Reality: standard ARMs, including all those sold to Fannie Mae, repay principal with every payment.
- Myth: the first adjustment is the only one that matters. Reality: the rate can change at every scheduled date afterward, within the caps.
See also
Common questions
13 questions
What happens when the initial rate period ends?
The rate resets to the current index plus the loan's margin, within the caps, and then adjusts at each scheduled interval. Your note states how long the initial rate lasts and when the first adjustment can happen.
Can I refinance out of an ARM?
Often. Many borrowers refinance into a fixed-rate loan before or after the first adjustment, but a refinance depends on your equity, credit and income at that time and comes with its own closing costs.
What index do ARMs use?
ARMs that Fannie Mae buys must use the 30-day average of the Secured Overnight Financing Rate (SOFR), published by the Federal Reserve Bank of New York. FHA ARMs can use SOFR or the one-year Constant Maturity Treasury index. Your loan documents name the index and the margin that is added to it at each adjustment.
Can my rate go down when it adjusts?
Yes. If the index has fallen, the rate can drop at an adjustment, and the per-adjustment cap limits decreases as well as increases. For ARMs sold to Fannie Mae, the rate can never fall below the margin. Your note shows the caps and any floor that apply.
Will I get notice before my rate changes?
Yes. In most cases, federal rules require a separate notice 210 to 240 days before the first payment at the new rate is due, which gives you time to plan or look at refinancing. After that, you get a notice 60 to 120 days before each payment change caused by a rate adjustment.
Will I be qualified at the starting rate?
Not necessarily. Federal ability-to-repay rules require lenders to look past a lower starting rate: depending on the loan, they consider payments at the fully indexed rate (the index plus the margin) or at the highest rate the loan allows in its first five years. Fannie Mae also requires a higher qualifying rate for ARMs with fixed periods of five years or less.
What do the three numbers in an ARM's caps mean?
ARM caps are often written as three numbers separated by slashes. In order, they usually describe the most the rate can change at the first adjustment, the most it can change at each later adjustment, and the most it can rise above the starting rate over the life of the loan. Some loans also set a floor, a minimum rate. The AIR table on your Loan Estimate states your loan's limits in plain terms.
Can I convert my ARM to a fixed rate?
Only if your loan includes a conversion option. Some ARMs let you switch to a fixed rate during set windows, with the new rate figured by a formula in your loan documents, and the lender may charge a processing fee. Under Fannie Mae's rules, a converted ARM can no longer be assumed by a buyer. Without a conversion feature, moving to a fixed rate means refinancing into a new loan.
Can a buyer assume my ARM when I sell?
Possibly. Fannie Mae notes that its ARMs are usually assumable, though some plans restrict it, and an assuming buyer generally has to be approved by the lender. Once an ARM has been converted to a fixed rate, it can't be assumed. Your note and program disclosure describe the assumption terms that apply to your loan, so review them before marketing the home with an assumable loan.
Can an ARM have a prepayment penalty?
Not a typical home loan for personal use. Federal ability-to-repay rules allow a prepayment penalty only on certain fixed-rate qualified mortgages that aren't higher-priced, so a consumer ARM secured by your home can't include one. Business-purpose loans, such as many investor loans, fall outside that rule and may have penalties. Your Loan Estimate states whether a prepayment penalty applies.
Where can I follow the index on my ARM?
Your note names the index and where it's published. Fannie Mae requires lenders to tell borrowers that the index can be monitored and where its value can be found; the 30-day average of SOFR used by Fannie Mae ARMs is published daily by the Federal Reserve Bank of New York. The note also explains how a replacement index would be chosen if the index stops being published.
How is an ARM different from a temporary buydown?
With a temporary buydown, the note rate is fixed for the life of the loan, and a prepaid subsidy lowers the payment during the early years; after that, you pay the full note-rate payment. With an ARM, the rate itself changes after the fixed period based on the index and margin, and it can go up or down. Fannie Mae allows buydowns on some ARMs, so the two features can also be combined.
What is the fully indexed rate?
It's the loan's current index value plus its margin, before any caps apply. It shows roughly where an ARM's rate would land if it adjusted today, which is why lenders use it when testing whether you can afford the loan. Fannie Mae also requires lenders to tell borrowers the current index and margin when the starting rate is below the market rate. If your starting rate is well below the fully indexed rate, expect an increase at the first adjustment unless the index falls.
This page explains how this type of loan generally works. Programs, guidelines and availability vary by lender and change often. Contact Ruben to see which options are available for your scenario today.