The difference in one sentence
With a fixed-rate mortgage the interest rate is set when you take out the loan and does not change, so the principal-and-interest payment is the same in year 30 as in year 1. With an ARM the rate stays put for an initial period and then adjusts at set intervals, so the payment can rise or fall. The Consumer Financial Protection Bureau (CFPB) sums up the trade: many ARMs start at a lower rate than fixed-rate loans, but you cannot know in advance how much interest you will pay, and if you cannot afford the higher payments you may lose the home.
How to read 5/1, 7/6 and 10/1
The CFPB handbook on ARMs explains the labels. The first number is the number of years the initial rate lasts. The second is how often the rate changes after that: a 1 means once a year, a 6 or 6m means every six months. So:
- 5/1 ARM: rate fixed for five years, then adjusts every year.
- 5/6 or 5/6m ARM: rate fixed for five years, then adjusts every six months.
- 7/6 ARM: rate fixed for seven years, then every six months.
- 10/1 ARM: rate fixed for ten years, then every year.
The time between changes is the adjustment period. Everything else, the index, the margin and the caps, decides how far each change can go.
Index plus margin
After the fixed period, an ARM's rate has two parts: interest rate = index + margin. The index is a published measure of interest rates that moves with the economy; the handbook names the U.S. prime rate and the Constant Maturity Treasury (CMT) rate as common ones. The margin is an extra percentage the lender adds to the index, and it does not change over the life of the loan. Both are shown on your Loan Estimate, so you can shop lenders for the lowest index plus margin.
Index plus margin is called the fully indexed rate. The starting rate can be below it. The handbook calls that a "teaser", "start" or "discounted" rate and gives this example: the fully indexed rate is 4.5% (index 2% plus margin 2.5%) and the teaser rate is 3%. Even if the index never moves, the rate rises from 3% to 4.5% when the teaser period ends. The starting rate is therefore not a forecast of the rate after the first change.
The three caps
Caps limit how far the rate can move. The CFPB describes three, and quotes the values that are common:
| Cap | What it limits | Common values |
|---|---|---|
| Initial adjustment cap | The first change after the fixed period, measured from the starting rate | 2 or 5 percentage points |
| Subsequent adjustment cap | Each later change, measured from the previous rate | 1 or 2 percentage points |
| Lifetime cap | The total change over the life of the loan, measured from the starting rate | 5 percentage points, sometimes more |
Written as 2/2/5, that is an initial cap of 2, a later cap of 2 and a lifetime cap of 5. A 5/2/5 loan can jump 5 points at the very first change. Some loans also have a floor, a lifetime limit on decreases that can differ from the limit on increases, and the handbook says an ARM's rate is generally never lower than the margin. Two lenders can offer the same starting rate with different caps, so compare the caps, not only the rate.
All of this is in the Adjustable Interest Rate (AIR) table on page 2 of your Loan Estimate: index plus margin, initial rate, minimum and maximum rate, when the first and later changes happen, and the limits on each change. The handbook's example reads: 1 Year CMT + 2.5%, initial rate 3%, minimum/maximum 2.5% / 8%, first change at the beginning of the 61st month, then every 12 months, limits of 2% on the first and on each later change.
Worked example: fixed loan against a 5/1 ARM, worst case
Take a $400,000 loan over 30 years. The fixed-rate offer is 6.25%, the 5/1 ARM starts at 5.5% with 2/2/5 caps. The rates are illustrations, not today's market. The fixed payment is $2,463 a month for principal and interest. The ARM starts at $2,271, which is $192 less, so over the five fixed years it saves $11,503.
Now assume the worst: the index rises enough that every cap binds. At the first change the rate goes up by the full initial cap, the year after by the full later cap, and then it hits the lifetime cap of 10.5%. Each new payment is computed on the remaining balance over the remaining term, the way servicers do it.
| Year | ARM rate | ARM payment | Fixed payment | Difference per month |
|---|---|---|---|---|
| 1 | 5.50% | $2,271 | $2,463 | −$192 |
| 2 | 5.50% | $2,271 | $2,463 | −$192 |
| 3 | 5.50% | $2,271 | $2,463 | −$192 |
| 4 | 5.50% | $2,271 | $2,463 | −$192 |
| 5 | 5.50% | $2,271 | $2,463 | −$192 |
| 6 | 7.50% | $2,733 | $2,463 | +$270 |
| 7 | 9.50% | $3,219 | $2,463 | +$756 |
| 8 | 10.50% | $3,467 | $2,463 | +$1,004 |
| 9 | 10.50% | $3,467 | $2,463 | +$1,004 |
| 10 | 10.50% | $3,467 | $2,463 | +$1,004 |
In this path the payment peaks at $3,467, about $1,004 a month more than the fixed loan, and years 6 to 10 cost $48,460 more than the fixed loan, which is more than the $11,503 saved in the first five years. In the best case the index never rises and the ARM stays cheaper for the whole term. The truth is usually somewhere in between, and nobody knows where in advance. Run your own numbers in the mortgage calculator with the starting rate and again with the maximum rate; the second result is the payment you have to be able to afford.
What to check before choosing
The CFPB does not tell you which loan to pick, but its guidance comes down to a short list of questions:
- How high can the rate and the payment go? Ask the lender for the highest payment you may ever have to pay, or read it off the Loan Estimate's AIR table and projected payments.
- Can you afford that payment on today's income? The CFPB's advice is direct: if you cannot, consider another loan. The home affordability calculator shows what share of your income the maximum payment would take.
- How long will you keep the loan? The CFPB warns against assuming you can sell or refinance before the rate changes: property values can fall and finances can change. If you do plan to move within the fixed period, the rent vs buy calculator helps check whether buying for that short a time pays at all.
- What does a refinance cost later? Switching an ARM to a fixed loan before the first change means paying closing costs again. The refinance calculator shows how many months a new loan needs to earn those costs back.
- Is there negative amortization? The handbook describes payment option ARMs, which let you choose a minimum payment that does not cover all of the interest due. Then the balance goes up instead of down. That is negative amortization, and it belongs on the list of things to ask about.
What a fixed rate buys you
A fixed-rate loan usually costs more per month at the start, because, as the CFPB notes, many ARMs begin at a lower rate than fixed-rate loans. In return the principal-and-interest payment never changes, you know the total interest for the whole term on day one, and you never have to re-qualify or refinance to keep the payment stable. The loan calculator shows that total for any rate and term, and the mortgage calculator adds taxes, insurance and PMI to get the full monthly amount.
Frequently asked questions
What does 5/1 ARM mean?
The first number is how many years the starting rate lasts, the second how often the rate changes after that. A 5/1 ARM keeps its rate for five years and then adjusts once a year. A 5/6m ARM adjusts every six months after year five, and a 7/6 or 10/6 works the same way with a seven- or ten-year fixed period. This is how the CFPB's handbook on adjustable-rate mortgages explains the labels.
How is the new rate set when an ARM adjusts?
Index plus margin, within the caps. The index is a published measure of interest rates, such as the Constant Maturity Treasury rate or the prime rate. The margin is a fixed percentage the lender adds and it stays the same for the life of the loan. Both are shown on your Loan Estimate. If the index is 4% and the margin is 2.5%, the fully indexed rate is 6.5%.
Can the payment on an ARM go down?
Yes, if the index falls, though the CFPB notes that not every ARM lets the payment fall. Loans also have a floor: the handbook says an ARM's rate is generally never lower than the margin, and some loans set a separate lifetime limit on decreases.
Does the APR of an ARM show the worst case?
No. The CFPB says that for adjustable-rate loans the APR does not reflect the maximum interest rate of the loan, and warns against comparing a fixed-rate APR with an ARM APR. To see the worst case, look at the maximum rate and the rate caps in the Adjustable Interest Rate table on page 2 of your Loan Estimate, or ask the lender for the highest payment you could ever have to make.
When will I be told about a rate change?
The CFPB handbook says your loan servicer tells you your new payment amount seven to eight months before the first change, so you can budget for it or shop for a new loan. Later changes come with advance notices as well.
Sources
- CFPB: What is the difference between a fixed-rate and adjustable-rate mortgage (ARM) loan?
- CFPB: With an adjustable-rate mortgage (ARM), what are rate caps and how do they work? (initial, subsequent and lifetime caps, common values, floors)
- CFPB: Consumer Handbook on Adjustable-Rate Mortgages (PDF): index and margin, 5/1 and 5/6m labels, the AIR table, teaser rates, negative amortization
- CFPB: What is the difference between a mortgage interest rate and an APR? (the APR of an ARM does not reflect its maximum rate)