Adjustable-Rate Mortgage (ARM) Terms Glossary

Adjustable-Rate Mortgage (ARM)

A mortgage with an interest rate that is fixed for an initial period, then adjusts periodically based on a market index. ARM rates are often lower than fixed rates initially. A 5/1 ARM means the rate is fixed for 5 years, then adjusts once per year after that.

Adjustment Cap (ARM)

A limit on how much an adjustable-rate mortgage's interest rate can change at each scheduled adjustment date. For example, a 2% periodic cap means the rate cannot increase or decrease by more than 2 percentage points at any single adjustment. Protects borrowers from sudden large payment increases.

Adjustment Date (ARM)

The date on which the interest rate on an adjustable-rate mortgage changes based on the current index value plus the lender's margin. Adjustment dates recur on a set schedule after the initial fixed period ends, commonly every 6 months or annually.

Adjustment Period (ARM)

The interval between interest rate changes on an adjustable-rate mortgage after the initial fixed period. A 5/1 ARM has an initial fixed period of 5 years, then adjusts once per year. The adjustment period is defined in the loan note.

Annual Adjustment Cap

A limit on how much an adjustable-rate mortgage's interest rate can change in any single calendar year, regardless of how much the underlying index has moved. Common caps are 1% or 2% per year. Provides a predictable ceiling on potential payment increases in any 12-month period.

Convertible ARM

An adjustable-rate mortgage with an option to convert to a fixed-rate mortgage at a specified time, typically during years one through five. Conversion usually requires a fee and is available only on certain loan programs. Useful for borrowers who want flexibility if rates fall during the adjustable period.

Floating Interest Rate

A mortgage rate that has not been locked and can change based on market conditions until the borrower locks in a rate. Floating your rate is a gamble that rates will decline before closing. Locking provides certainty. Most borrowers lock within a few days of application or when their offer is accepted.

Fully Indexed Rate (ARM)

The interest rate on an adjustable-rate mortgage calculated by adding the current index value to the lender's margin. The fully indexed rate is what the rate would adjust to today if the initial fixed period ended. Lenders must use the fully indexed rate or a floor rate (whichever is higher) for qualifying purposes.

Initial Rate Period

The starting period of an adjustable-rate mortgage during which the rate is fixed. On a 5/1 ARM the initial rate period is 5 years. After that the rate adjusts on the schedule defined in the note, subject to periodic and lifetime caps.

Interest Rate Cap

A limit on how much the interest rate on an adjustable-rate mortgage can change. ARMs typically have a periodic cap that limits each adjustment and a lifetime cap that limits the total increase over the life of the loan. Common cap structures are 2/2/5 or 5/2/5.

Interest Rate Ceiling

The maximum interest rate an ARM can ever reach, regardless of how much the underlying index increases. Also called the lifetime cap. The difference between the initial rate and the ceiling determines the worst-case payment scenario, which borrowers should calculate before choosing an ARM.

Interest Rate Floor

The minimum interest rate that can be charged on a variable rate loan. Ensures the lender always earns at least a minimum return even if the index drops significantly. Less relevant to borrowers than the cap, but relevant in declining rate environments.

Interest-Only Payments

Monthly loan payments that cover only the accrued interest with no reduction to the principal balance. Common in certain adjustable-rate mortgages during the initial period and in some DSCR and bridge loan programs. Payments are lower than fully amortizing payments, but the balance does not decrease. After the interest-only period, payments increase to cover both principal and interest.

Lifetime Cap

The maximum amount an adjustable-rate mortgage's interest rate can rise above the original start rate over the life of the loan. A 5% lifetime cap on a loan that starts at 6.5% means the rate can never exceed 11.5%, even if the underlying index rises higher than that.

Margin (ARM)

The fixed percentage a lender adds to the index rate to determine the interest rate on an adjustable-rate mortgage. The margin does not change over the life of the loan. If the SOFR index is 4.5% and the lender's margin is 2.5%, the borrower's rate is 7% at the next adjustment.

Negative Amortization

A situation where the monthly loan payment is less than the interest accruing on the balance, causing the principal to increase rather than decrease. Can occur with certain ARM structures or interest-only periods. Results in owing more than the original loan amount despite making payments.

Option ARM

An ARM that offered multiple monthly payment options: minimum payment (which could cause negative amortization), interest-only, 30-year amortizing, or 15-year amortizing. Largely eliminated from the market after the 2008 financial crisis. Not available under current Qualified Mortgage standards, which prohibit negative amortization. Included here for educational context when reviewing older mortgages.

Payment Change Date

The date on which a new monthly payment amount takes effect on an adjustable-rate mortgage following an interest rate adjustment. Typically occurs one month after the adjustment date. Lenders are required to notify borrowers 60 to 120 days before a payment increase takes effect, giving time to plan for higher payments.

Start Rate

The initial interest rate on an adjustable-rate mortgage, also called the teaser rate or initial rate. The start rate is fixed for the initial rate period (commonly 3, 5, 7, or 10 years) before the first adjustment occurs. Start rates are typically lower than the fully indexed rate (index plus margin), which is the rate the loan would adjust to if the initial period ended today.

Treasury Index

A benchmark interest rate based on US Treasury securities used as the index for some ARM products. The 1-year Constant Maturity Treasury (1-year CMT) was a common ARM index. The Secured Overnight Financing Rate (SOFR) has largely replaced LIBOR-based indices since 2023 and is now more common for new ARMs.

Variable Rate

An interest rate that can change over time based on movements in an underlying index. Used on adjustable-rate mortgages, HELOCs, and some second mortgages. Different from a fixed rate, which never changes. Variable-rate loans usually start with a lower rate but carry the risk of future increases.