An ARM is a contract with two phases. During the initial period, the rate is fixed. After that, the rate can change at set intervals for the rest of the term. How it changes is written in the note before closing: which index the loan follows, what margin is added, how often it adjusts, and the caps that limit the changes. Nothing about the later rate is left to the lender's discretion.
Because the borrower takes on some rate risk after the initial period, the starting rate on an ARM is often priced below a fixed rate on the same loan. Whether that tradeoff makes sense depends on how long the borrower expects to keep the loan and how much rate movement they can absorb.
In a name like 5/6 or 7/6, the first number is how many years the initial rate holds. The second is how often the rate can change after that, in months. A 7/6 ARM holds the starting rate for seven years and can then adjust every six months. Older loans often adjusted once a year and are named like 5/1 or 7/1.
The rest of the loan is usually a 30-year term, so a 7/6 ARM still amortizes over 30 years. The payment is recalculated at each adjustment using the new rate, the current balance, and the remaining months.
The index is a published market rate the lender has no control over. Most new ARMs sold to Fannie Mae and Freddie Mac now use the Secured Overnight Financing Rate, known as SOFR, usually in a 30-day average form. Older loans used LIBOR, which was retired, and those loans were moved to replacement indexes.
The margin is a fixed number of percentage points stated in the note. It does not change for the life of the loan.
At each change date, the servicer looks up the index value as of a date the note specifies, adds the margin, and rounds as the note directs. That sum is the fully indexed rate. The new rate is the fully indexed rate, limited by the caps.
The note does not change just because the Federal Reserve changed its policy rate. It changes when the index in that note changes, on that note's schedule, inside the caps. The rate can also go down if the index is lower at the change date. Many notes also set a floor, often tied to the margin, below which the rate cannot fall.
Caps are the borrower's protection, and they are written as a set of three limits:
The cap structure is part of the product and differs by investor and ARM type. A lender can tell you exactly what each cap is for the ARM you are quoted, and the Loan Estimate shows the result in its Adjustable Interest Rate table, including the highest possible rate and when it could first be reached. The Loan Estimate also shows, in the projected payments table, the range of principal-and-interest payments in later years based on those caps.
The payment used to qualify is not always the starting payment. The guideline for that program says which rate to use. Some programs qualify the borrower at a higher rate than the initial rate, often tied to the fully indexed rate or the initial rate plus a margin, so the borrower can carry the payment if the rate rises. Under the federal ability-to-repay rule, the lender considers the payment at the greater of the fully indexed rate or the introductory rate, and the qualified mortgage rules look at the highest rate that can apply during the first five years. Those federal floors sit underneath whatever the investor's guide adds.
Some programs restrict ARMs. Fannie Mae HomeReady does not allow an ARM in the 95.01 to 97 percent loan-to-value band. Source: Fannie Mae Selling Guide B5-6-01. FHA and VA have their own ARM products with their own cap structures.
Federal rules require specific disclosures for ARMs. Early in the process the lender provides the Consumer Handbook on Adjustable-Rate Mortgages, published by the CFPB, and a program disclosure that describes the specific ARM. The Loan Estimate and Closing Disclosure show the index, margin, caps, and payment ranges.
After closing, the servicer has to send notices before rate changes. Federal rules require an initial notice well ahead of the first payment change and then notices before each later change that alters the payment. The notice shows the new rate, the new payment, and how it was calculated. A borrower who keeps the note and these notices can check the math.
Walking through one adjustment makes the mechanism concrete. Some months before the first change, the servicer sends the required notice. On the lookback date the note names, a set number of days before the change date, the servicer looks up the index. It adds the margin, rounds as the note directs, and compares the result with the starting rate. If the fully indexed rate is higher than the starting rate by more than the initial cap allows, the new rate stops at the cap. If it is lower, the rate drops, down to any floor. The servicer then recalculates the payment so the remaining balance pays off over the remaining months at the new rate. Taxes and insurance in escrow are unaffected by this step and follow their own annual analysis.
Six months later on a 7/6 ARM, the same process repeats under the periodic cap, and it keeps repeating for the life of the loan, always inside the lifetime cap.
Fictional example: a buyer asks for "the ARM" because someone said it is cheaper. The useful comparison is the initial period, the index, the margin, the caps, and a fixed-rate quote with the same points. No rate from that conversation belongs in a library. It would be stale the next morning.
A reasonable way to compare is to ask three questions:
A borrower relocating for work on a known timeline might find an ARM's initial period covers the time they expect to own the home. A borrower who plans to stay for decades usually leans toward a fixed rate, though some choose an ARM planning to refinance later. That plan depends on rates and the borrower's file at that time, and neither is guaranteed.
Many ARM borrowers refinance into a fixed rate before or after the first adjustment. That is a new loan with new underwriting, a new appraisal unless waived, and new closing costs. On a Texas homestead, a refinance that only replaces the existing debt is a rate-and-term refinance. Taking cash out is a different constitutional loan with its own rules. The decision to refinance depends on the costs, the new rate, and how long the owner expects to stay.
For how quotes on the same day can differ between lenders, see why quotes differ. For buying the rate down instead, see discount points.
If you are weighing an ARM because you expect to move or refinance, I can put a specific ARM next to a fixed loan with the same points and show you the payment at the first cap. Book a call, or start an application.
Links checked Oct 21, 2026.
About the author: McKade Lively, NMLS 2704474, American Pacific Mortgage Corporation dba True North Home Loans, NMLS 1850.
Equal Housing Opportunity.
Last reviewed: Oct 2026