Adjustable Rate Mortgage (ARM) Explained: How ARMs Work in 2025

An adjustable-rate mortgage (ARM) has an interest rate that starts lower than fixed rates but changes after an initial fixed period. A 5/1 ARM stays fixed for 5 years, then adjusts annually based on a market index plus a margin. ARMs typically offer rates 0.5-1% lower than 30-year fixed mortgages initially, making them attractive for buyers who plan to sell or refinance within 5-7 years.

How ARMs Work

ARMs have two phases: a fixed-rate period and an adjustable period.

The Fixed Period

During the initial years, your rate doesn’t change. Common fixed periods:

ARM Type	Fixed Period	Then Adjusts
5/1 ARM	5 years	Every year
7/1 ARM	7 years	Every year
10/1 ARM	10 years	Every year
5/6 ARM	5 years	Every 6 months
7/6 ARM	7 years	Every 6 months

The Adjustment Period

After the fixed period, your rate changes based on:

Index: A benchmark rate the ARM follows (SOFR is most common now)

Margin: The lender’s markup, typically 2-3%

Your new rate = Index + Margin

Example:

• Index (SOFR): 5.0%
• Margin: 2.5%
• New rate: 7.5%

Rate Caps Protect You

Caps limit how much your rate can change.

Initial adjustment cap: Maximum change at first adjustment (typically 2%)

Periodic cap: Maximum change at each subsequent adjustment (typically 2%)

Lifetime cap: Maximum change over life of loan (typically 5%)

Cap notation: 2/2/5 means 2% initial, 2% periodic, 5% lifetime

Example with 2/2/5 caps:

• Starting rate: 5.5%
• First adjustment max: 7.5% (5.5% + 2%)
• Next adjustment max: 9.5% (7.5% + 2%)
• Lifetime maximum: 10.5% (5.5% + 5%)

ARM vs Fixed Rate Comparison

Initial Rate Advantage

ARMs start lower than fixed-rate loans:

Loan Type	Typical Rate	Monthly P&I on $350K
30-year fixed	6.75%	$2,270
5/1 ARM	5.75%	$2,043
7/1 ARM	6.00%	$2,098
10/1 ARM	6.25%	$2,155

The 5/1 ARM saves $227/month initially—$13,620 over the first 5 years.

Payment Stability Comparison

Feature	Fixed Rate	ARM
Initial rate	Higher	Lower
Rate changes	Never	After fixed period
Payment changes	Never	Can increase or decrease
Predictability	Complete	Partial
Best for	Long-term owners	Short-term owners

Total Cost Scenarios

$350,000 loan, comparing 30-year fixed at 6.75% vs 5/1 ARM at 5.75%:

If you sell in year 5:

• Fixed: $136,200 paid (mostly interest)
• ARM: $122,580 paid
• ARM saves: $13,620

If rates rise 2% at adjustment and you keep loan:

• Years 1-5: ARM saves $13,620
• Years 6-10: ARM at 7.75% costs more
• Break-even: Around year 8

If rates stay flat or drop:

• ARM wins for the entire loan term

When ARMs Make Sense

You’ll Sell Before Adjustment

If you know you’re moving within 5-7 years, an ARM’s lower rate saves money without exposure to adjustments.

Good candidates:

• Career requires relocation
• Starter home—plan to upgrade
• Investment timeline known
• Temporary job assignment

Marcus bought a condo with a 5/1 ARM knowing he’d upgrade to a house after his kids started school. He sold in year 4, saving $11,200 compared to a fixed rate and never facing an adjustment.

You’ll Refinance Before Adjustment

If rates drop significantly, you’d refinance regardless of loan type. The ARM gives you lower payments while you wait for the right opportunity.

You Can Handle Payment Increases

If your budget has significant room and you could absorb a worst-case payment increase, the initial savings might be worth the risk.

Worst-case calculation (5/1 ARM at 5.75%, 2/2/5 caps):

• Current payment: $2,043
• After first adjustment (rate = 7.75%): $2,432
• After second adjustment (rate = 9.75%): $2,860
• Maximum possible (rate = 10.75%): $3,095

Can you afford $3,095/month if rates max out?

Rates Are Expected to Fall

If market indicators suggest rates will decline, an ARM positions you to benefit automatically when adjustments occur.

When to Avoid ARMs

You’re Buying Your Forever Home

If you’ll stay 15+ years, fixed-rate stability outweighs ARM’s initial savings. One bad rate environment could cost you significantly.

You Can’t Handle Payment Increases

If an increased payment would strain your budget, the risk isn’t worth the initial savings.

You’re Risk-Averse

If payment uncertainty causes stress, a fixed rate provides peace of mind worth paying for.

You’re at Maximum DTI

If you’re already stretching to qualify, you have no cushion for payment increases.

ARM Rate Indexes

Your adjustment is based on an index. The most common today is SOFR.

SOFR (Secured Overnight Financing Rate)

• Replaced LIBOR as the standard index
• Based on Treasury repurchase agreements
• Published daily by the Federal Reserve
• Currently around 5.0-5.5%

How the Index Affects You

Your rate = Index + Margin

If SOFR is 5.0% and your margin is 2.5%, your rate is 7.5%.

If SOFR drops to 3.0%, your rate drops to 5.5% at next adjustment.

If SOFR rises to 7.0%, your rate rises to 9.5% (subject to caps).

ARM Payment Examples

5/1 ARM: Best Case

$300,000 loan, 5.75% start rate, rates fall 1% at first adjustment:

Year	Rate	Monthly Payment
1-5	5.75%	$1,751
6-7	4.75%	$1,565
8+	4.75%	$1,565

You save on lower payments, and adjustments work in your favor.

5/1 ARM: Worst Case

$300,000 loan, 5.75% start rate, 2/2/5 caps, rates rise to max:

Year	Rate	Monthly Payment
1-5	5.75%	$1,751
6	7.75%	$2,084
7	9.75%	$2,450
8+	10.75%	$2,653

Your payment increases $902/month—a 52% increase from initial payment.

7/1 ARM: Moderate Scenario

$300,000 loan, 6.0% start, rates rise 1% then stabilize:

Year	Rate	Monthly Payment
1-7	6.0%	$1,799
8+	7.0%	$1,969

Moderate increase, but you saved significantly during years 1-7.

ARM Qualification

Qualifying Rate

Lenders qualify you at a higher rate than the start rate to ensure you can handle increases.

Typical qualifying rate: Initial rate + 2%, or fully indexed rate (index + margin), whichever is higher.

Example:

• ARM start rate: 5.75%
• Qualifying rate: 7.75%
• You must afford payments at 7.75%, not 5.75%

Credit Requirements

ARMs have similar credit requirements to fixed-rate loans:

• Conventional: 620 minimum
• Better rates at 700+
• Best rates at 740+

Down Payment

Same as fixed-rate conventional:

• Minimum 3% down
• 20% eliminates PMI
• Larger down = better rate

ARM vs Fixed: Decision Framework

Choose ARM If

1. You’ll sell within the fixed period
2. You’ll refinance before adjustment
3. You have significant budget flexibility
4. You expect rates to decline
5. The initial savings are substantial (0.75%+)

Choose Fixed If

1. You’re staying long-term
2. Payment stability is important
3. You’re at maximum comfortable payment
4. You expect rates to rise significantly
5. The ARM savings are minimal (<0.5%)

Calculate Your Savings

Step 1: Get quotes for both ARM and fixed

Step 2: Calculate monthly savings during fixed period

Step 3: Multiply by months in fixed period

Step 4: Compare to risk of staying past adjustment

Example:

• Fixed: $2,300/month
• 5/1 ARM: $2,100/month
• Monthly savings: $200
• 5-year savings: $12,000

Is $12,000 worth the adjustment risk? Depends on your plans.

Frequently Asked Questions

What does 5/1 ARM mean?

The first number (5) is years at the fixed rate. The second number (1) is how often the rate adjusts after that. So 5/1 = fixed for 5 years, adjusts every 1 year after.

How much can an ARM rate increase?

Depends on your caps. Typical caps are 2/2/5: 2% at first adjustment, 2% at each subsequent adjustment, 5% maximum over the life of the loan. Your loan documents specify your exact caps.

Are ARMs a bad idea?

Not necessarily. ARMs are risky for long-term owners or those on tight budgets. They’re smart for short-term owners who’ll sell or refinance before adjustment. The key is matching the loan to your situation.

What happens when my ARM adjusts?

Your lender recalculates your rate using the current index plus your margin. Your payment changes to reflect the new rate. You’ll receive notice 30-60 days before adjustment.

Can I refinance out of an ARM?

Yes. You can refinance an ARM to a fixed-rate mortgage anytime. Many ARM borrowers refinance before their first adjustment, especially if rates have dropped.

Is a 7/1 ARM better than a 5/1 ARM?

The 7/1 has a longer fixed period (7 years vs 5) but usually a slightly higher starting rate. Choose 7/1 if you want more protection but still expect to move or refinance within 7-10 years.