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GlossaryMortgageLoan basics

Adjustable-rate mortgage

2 min read
Short answer
An adjustable-rate mortgage carries a fixed rate for an introductory period and then adjusts periodically for the rest of the term. The new rate is a published index plus a fixed margin, bounded by caps on the first adjustment, each later adjustment, and the lifetime increase. The introductory rate is usually lower than a comparable fixed rate, which is what the borrower is being paid to accept the uncertainty.

An adjustable-rate mortgage carries one rate for an introductory period, then adjusts on a schedule for the rest of the term. The trade is explicit: a lower starting rate in exchange for taking on the risk of what rates do later.

How the new rate is set#

Two components, and only one of them moves.

The index is a published rate the lender does not control. Most US ARMs now reference SOFR-based indices, which replaced LIBOR.

The margin is a fixed number added to the index, set at origination and unchanged for the life of the loan.

Index plus margin is the fully indexed rate. When people say an ARM "adjusted", what happened is that the index moved and the margin was added to the new value.

The three caps#

Every ARM is bounded, and the bounds are on the note.

An initial cap limits how far the first adjustment can move. A periodic cap limits each adjustment after that. A lifetime cap sets the ceiling above the start rate for the whole term.

They are usually written as three numbers together — 2/2/5, for instance. That tells you the worst case exactly, which means the maximum possible payment is calculable on the day you sign. Very few borrowers calculate it.

Naming#

The two numbers in an ARM's name describe timing, not rates. The first is the years the introductory rate holds; the second is how often it adjusts afterwards. A 5/1 holds five years then adjusts annually. A 7/6 holds seven then adjusts every six months.

Why they matter to distressed property#

Adjustable-rate lending was central to the 2007 wave, and the mechanism was not complicated: introductory rates expired, payments reset upward, and households that qualified at the teaser rate could not pay the indexed one.

That is a different failure mode from the escrow drift that pushes fixed-rate payments up. Rate shock arrives on a known date in a large step. Escrow shock arrives annually in smaller ones. Both end in the same place.

What to do before a reset#

The useful work happens before the adjustment, not after.

Calculate the payment at the fully indexed rate, using the current index value plus your margin, capped at the initial cap. That is the realistic worst case for the first reset.

If it does not work, the options — refinance, sell, or ask the servicer about a modification — are all considerably better while the loan is current. A clean payment history is an asset, and it stops being one the month a payment is missed.

Common questions

What does 5/1 or 7/6 mean on an ARM?
The first number is the years the introductory rate lasts. The second is how often it adjusts afterwards — a 1 means annually, a 6 means every six months. A 7/6 ARM holds its rate for seven years and then adjusts twice a year for the remaining twenty-three.
How high can an ARM rate go?
Three caps bound it: a cap on the first adjustment, a cap on each subsequent adjustment, and a lifetime cap above the start rate. They appear on the loan documents as three numbers. The worst case is knowable at closing and is worth calculating before signing rather than after.
Should I worry if my ARM is about to adjust?
Work out the new payment at the fully indexed rate before the reset, not after. If it is unaffordable, the window to refinance or sell is before the adjustment, while the payment history is still clean and the equity position is unchanged.
Keep reading
Fixed-rate mortgage
A mortgage whose interest rate stays the same for the whole term, so the principal and interest portion of the payment never changes.
Amortization
The gradual repayment of a loan through regular payments that cover interest first and reduce principal by a growing amount each period.
Negative amortization
A loan balance that grows rather than shrinks, because the scheduled payment is less than the interest accruing on it.