A fixed rate mortgage has a set interest rate for the entire term of the loan, so the monthly principal and interest payment never change. You can choose from shorter or longer terms, typically 15, 20, or 30 years.
An adjustable rate mortgage, or ARM, has a set interest rate for an initial period, and then can adjust periodically over the remainder of the loan term. The monthly principal and interest payment can change after the initial period. ARMs are typically 30 year loans but you can choose shorter or longer terms.
You can choose from a shorter or longer fixed period and adjustment frequency. The number structure used to describe the ARM indicates the length of the fixed period and the frequency the interest rate can adjust afterward. For example, a 5/1 ARM is fixed for the first five years of the loan and then can adjust annually after.
During the adjustable period ARM’s have a set margin to a benchmark rate (the ‘index’), the LIBOR, SOFR, or the Prime Rate are common indexes. If the set margin is 2%, and the index rate is 3%, the loan interest rate will be 5%. If the index rate has risen or fallen at the next adjustment date, the interest rate can change up or down to maintain the set 2% margin.
ARMs typically have a maximum amount the rate can change, known as ‘caps’. An ARM with caps of 5/2/5 can change as much as 5% at the first adjustment, up to 2% each subsequent adjustment, and not more than 5% over the life of the loan.
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