The initial rate and payments in the first few years of an adjustable-rate mortgage (ARM) can differ significantly from those later in the loan’s term. Before committing to an ARM, ask your lender for the annual percentage rate (APR), which reflects the overall cost of the loan, including interest and fees. Comparing the APR to the initial interest rate can help you understand how much higher your costs might be after the initial period ends, even if interest rates remain stable.

ARMs typically have specific adjustment periods during which the interest rate and monthly payment can change. These adjustment periods are defined in the loan terms and may occur monthly, quarterly, or annually. For example, a loan with a one-year adjustment period is called a one-year ARM, meaning the interest rate and payment can change once every year. Similarly, a loan with a five-year adjustment period is referred to as a five-year ARM.

The interest rate for an ARM is based on two main components: the index and the margin. The index reflects prevailing interest rates and is variable, while the margin is an additional fixed amount your lender adds. After the initial fixed-rate period ends, your monthly payments will be determined by the fully indexed rate, which is the sum of the index and the margin. For example, if the index increases, your interest rate and monthly payments will likely rise as well. Conversely, if the index decreases, both your interest rate and monthly payments may go down.

It’s also important to note that caps—limits on how much the interest rate or payment can increase during adjustment periods or over the life of the loan—can influence these changes.
ARM rates vary among lenders, but most use common indexes to determine interest rates. Popular indexes include the one-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). Some lenders may also use their own cost of funds as an index. Before choosing a lender, inquire about the index they use and how it fluctuates to better understand what to expect from that lender and loan.

The margin is a percentage added to the interest rate on an ARM and typically remains consistent over the life of the loan. The index plus the margin is referred to as the fully indexed rate. For instance, if a lender uses an index of 3% and adds a 3% margin, the fully indexed rate would be 6%. Some lenders adjust the margin based on your credit score, meaning a higher credit score could result in a lower margin and reduced interest costs over the life of your loan.