Adjustable-rate mortgage: Money saver or budgeting headache?
If you’re buying a home or other property, it’s a good bet you’ll need a mortgage. One of the first decisions you’ll face is whether to go with an adjustable-rate mortgage or a fixed-rate loan.
Understanding how these two options work can benefit anyone, whether you’re a first-time homebuyer or a small real estate investor. A little knowledge could save you thousands in mortgage interest and help you avoid the surprise of higher monthly payments when rates change.
Key Points
- Adjustable-rate mortgages often start with teaser rates that are lower than fixed-rate mortgages.
- ARM loans include caps to reduce the risk of sharp payment hikes.
- Consider whether an ARM makes sense for your budget, risk tolerance, and homeownership plans.
ARM yourself: What is an adjustable-rate mortgage?
An adjustable-rate mortgage (also called a variable-rate mortgage) is a home loan with an interest rate that changes periodically, typically after an initial fixed period. When the rate changes, your monthly payments can go up or down. With a fixed-rate mortgage, you keep the same interest rate for the entire term, so your monthly payments (principal and interest) stay consistent.
Less common types of ARMs
Most adjustable-rate mortgages are hybrid ARMs, meaning they start with a fixed rate for a defined period before switching to a variable rate. But some ARMs work a little differently:
- Interest-only ARMs allow you to pay only interest for a set period—typically during the fixed-rate phase—before principal payments begin. They can be riskier if you’re not prepared for the payment increase.
- Fully indexed ARMs have no fixed-rate period. Your rate adjusts from the start of the loan based on market conditions.
These alternatives are less common and generally better suited to experienced borrowers or specific financial strategies.
ARMs have two distinct phases: a fixed-rate period followed by a mortgage-adjustment period.
Fixed for now: How the fixed-rate period works. During the initial period, your loan’s interest rate stays the same—and it’s often lower than the rate on a traditional 30-year fixed mortgage, which is why it’s sometimes called a teaser rate. This time frame typically lasts six months to 10 years, depending on the loan.
A 30-year term is common, but the fixed rate applies only to the initial period. ARM loans are commonly labeled with what look like improper fractions, such as 5/1, 7/1, or 10/1. The first number shows how many years the rate stays fixed; the second shows how often it adjusts after that—usually once a year.
Adjusting expectations: What happens during the mortgage-adjustment period. After the fixed-rate period ends, your mortgage enters its variable-rate period, and the interest rate will be subject to change—typically once a year. The new rate is tied to current market conditions and determined by your loan’s specific terms. It could go up, down, or stay the same, depending on what’s happening in the broader economy.
For example, with a 5/1 ARM, your interest rate is fixed for the first five years. Starting in year six, it can adjust annually for the remaining 25 years of the 30-year loan term.
Rate math: How ARM interest rates are set
When your lender adjusts your mortgage rate, it bases the decision on two key components: the index rate and the margin. These two figures added together equal your new interest rate.
- Index rate. As of 2025, most ARM loans are based on the Secured Overnight Financing Rate (SOFR), which replaced the London Interbank Offered Rate (LIBOR) as the benchmark in 2023. SOFR reflects the cost of borrowing cash overnight in the U.S. Department of the Treasury repurchase market (repo market).
- Margin. The mortgage lender adds a percentage—called the margin—to the index to determine your new interest rate. The margin is a fixed percentage set by your lender and written into your loan agreement; it doesn’t change after you’ve closed on your loan. The size of the margin depends on the lender and the loan.
Capping it off: How interest rate caps limit increases
ARM loans are required by federal law to include limits on interest rate increases during the variable period. These interest rate caps help protect borrowers from extreme hikes in payments and are a standard part of consumer loan agreements:
- Initial adjustment caps limit how much your rate can increase when your rate first adjusts.
- Periodic adjustment caps restrict how much your rate can change during subsequent periods.
- Lifetime caps set the maximum amount the interest rate can rise—or fall—over the loan’s term.
For example, consider a 5/1 ARM with a 5/2/5 cap structure. The 5/1 means the interest rate is fixed for the first five years; the 1 means the rate will adjust once a year. The 5/2/5 cap structure tells you how much the rate can change:
- The first 5 is the initial adjustment cap. It means your rate can increase by up to 5 percentage points the first time it adjusts.
- The 2 is the periodic adjustment cap. After the initial change, your rate can rise or fall by no more than 2 percentage points each year.
- The final 5 is the lifetime cap. It guarantees your rate can’t increase more than 5 percentage points above your starting rate over the life of the loan.
Suppose the initial interest rate is 5% for the first five years. In this example, the 5/2/5 cap structure would allow the rate to rise to as much as 10% in year six—a jump of 5 percentage points that also hits the lifetime cap. After that, the periodic cap would permit changes of up to 2 percentage points each year, but only if the rate stays within the lifetime cap. So in year seven, the rate could fall to 8% if market conditions improve, but it couldn’t rise above 10%.
Plan B: Refinance before rates rise
Some borrowers choose an adjustable-rate mortgage intending to refinance the loan before the fixed-rate period ends. The idea is simple: Rather than accept a steep rate hike, you refinance into a new ARM or fixed-rate loan with better terms—ideally shaving off at least 1 percentage point to offset closing costs.
This strategy works best if you:
- Have a strong credit score and expect to qualify for good terms again
- Expect mortgage rates to remain stable or fall
- Can afford the closing costs associated with refinancing
Of course, refinancing isn’t guaranteed. If rates have climbed or your financial situation changes, you might not qualify for a better deal. That’s why refinancing should be part of your plan—but not your only plan.
As you compare ARM options, review the terms for both fixed and variable loans—along with the interest rate caps—to understand how much your payments might change over time.
Call to ARMs: When an ARM might make sense
Adjustable-rate mortgages aren’t for everyone, but they can make sense under the right circumstances.
- Short-term purchase—if you expect to sell your home before the fixed-rate period ends.
- Competitive teaser rate—if the initial rate is significantly lower than fixed-rate mortgages.
- Larger loan amount—if you’re borrowing a significant sum, even a small difference in interest rates can result in meaningful savings during the fixed period.
How an ARM could lower your payment
Suppose you’re buying a $550,000 home with 20% down, financing $440,000 over 30 years, and comparing monthly payments for a fixed-rate mortgage with a 10/1 ARM:
- 30-year fixed-rate mortgage at 7%: $2,930 a month
- 10/1 ARM at 6%: $2,640 a month
Monthly savings: About $290
10-year savings: Nearly $35,000
That kind of difference could free up room in your budget—or help you build equity faster. Just keep in mind that once the fixed-rate period ends, the interest rate on an ARM can adjust annually based on market conditions.
Don’t break your ARM: Risks of adjustable-rate mortgages
The initial rate on ARMs can look compelling, making these loans seem like a sensible choice. But if your rate adjusts up to the maximum, you’re responsible for the higher monthly payment—a risk that requires careful consideration.
- Payment uncertainty. After the fixed-rate period ends, your interest rate may adjust annually—potentially increasing your monthly mortgage payment significantly. If you’re on a tight budget, affording your new payment could be a challenge.
- Variable means vigilance. You’ll need to keep an eye on interest rate trends. If rates rise, your payments could follow.
The bottom line
An adjustable-rate mortgage can offer lower initial payments, but it also brings uncertainty once the fixed period ends. Whether an ARM makes sense for you depends on how long you plan to stay in your home, how steady your income is, how much interest rate risk you’re comfortable with—and how much you’re borrowing. The more you borrow, the more an initial rate difference could affect your payments.
Before you choose a mortgage, consider your timeline, financial cushion, and your ability to handle potential changes in your interest rate. A little planning now can save you a lot later.