An ARM typically starts with a lower rate than a fixed-rate mortgage during the initial period. After the initial period, the rate adjusts based on a financial index (like the Treasury rate or SOFR) plus the lender's margin. ARMs have rate caps that limit how much the rate can change: periodic caps limit each adjustment, lifetime caps limit total increases over the loan life, and payment caps limit monthly payment changes. A 5/1 ARM means the rate is fixed for 5 years, then adjusts annually.
A borrower gets a 5/1 ARM at 5% initial rate with a 2% periodic cap and 6% lifetime cap, margin of 2.5%. After 5 years, if the index is 4%, the new rate would be 4% + 2.5% = 6.5%. But the periodic cap limits the increase to 7% (5% + 2%). The rate can never exceed 11% (5% + 6% lifetime cap).
Know the components: Index + Margin = Fully Indexed Rate. Understand the three types of caps: periodic (per adjustment), lifetime (total increase), and payment cap. A common exam question: "What is the maximum rate?" Answer: Initial rate + lifetime cap. The margin stays the same throughout the loan.
Related Terms
Related Concepts
A conventional loan is a mortgage that is not insured or guaranteed by a government agency such as the FHA, VA, or USDA. It is originated and funded by private lenders and may be conforming or non-conforming.
An FHA loan is a mortgage insured by the Federal Housing Administration that allows lower down payments and credit scores than conventional loans. It is designed to help first-time homebuyers and borrowers with limited resources.
A VA loan is a mortgage guaranteed by the Department of Veterans Affairs available to eligible veterans, active-duty service members, and surviving spouses. It offers no down payment and no private mortgage insurance requirements.
A fixed-rate mortgage has an interest rate that remains constant for the entire term of the loan, resulting in equal monthly principal and interest payments throughout the life of the mortgage.
The loan-to-value ratio (LTV) is the percentage of a property's appraised value or purchase price (whichever is lower) that is being financed through a mortgage. LTV = Loan Amount / Property Value.
Frequently Asked Questions
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