How an Adjustable Period Works
An adjustable-rate mortgage is often described with two numbers, such as a 5/1 or 7/1 ARM. These numbers explain the loan’s structure:
- The first number indicates the length of the initial fixed-rate period in years.
- The second number indicates the adjustable period—how often the rate can change after the fixed period ends.
For example, with a 5/1 ARM:
- Your interest rate is fixed for the first 5 years.
- After that, your rate can adjust once every year. This one-year timeframe is the adjustable period.
During each adjustment, the lender calculates your new interest rate by adding a pre-set number called the margin to a variable benchmark rate, known as the index (e.g., the SOFR index). While the margin is constant, the index fluctuates with market conditions, causing your payment to change.
Example of an Adjustable Period in Action
Imagine you have a $300,000, 30-year 5/1 ARM with an initial rate of 5.5%.
- Years 1-5: Your interest rate is locked at 5.5%. Your principal and interest payment is stable and predictable.
- Start of Year 6: Your first rate adjustment occurs. Your lender recalculates your rate based on the current index plus your margin. If market rates have risen, your monthly payment will increase. If they have fallen, your payment will decrease.
- Start of Year 7 (and beyond): Your rate adjusts again based on the index, and this continues annually for the rest of the loan term.
Why Is the Adjustable Period Important?
Understanding the adjustable period is crucial because it determines your financial risk after the initial fixed period. A shorter adjustable period (e.g., one year) means your payments can change more frequently, creating budget uncertainty. A longer period (like in a 5/5 ARM) offers more stability between adjustments.
An ARM can be a strategic choice for homebuyers who:
- Plan to sell their home or refinance their mortgage before the first adjustment period begins.
- Expect interest rates to fall in the future, which would lead to lower payments.
- Are comfortable with the risk of potentially higher payments in exchange for a lower initial rate compared to a fixed-rate mortgage.
Interest Rate Caps: Your Protection Against Extreme Changes
To protect borrowers from severe payment shock, ARMs include interest rate caps, which limit how much your rate can increase. According to the Consumer Financial Protection Bureau (CFPB), there are three main types of caps you should review in your loan estimate:
- Initial Adjustment Cap: Limits the rate increase at the very first adjustment.
- Periodic Adjustment Cap: Restricts how much the rate can change in subsequent adjustment periods.
- Lifetime Cap: Sets a maximum interest rate you could ever be charged over the life of the loan.
These caps are a critical feature of an ARM, providing a ceiling on your potential interest rate and offering a degree of predictability in a variable-rate environment.