Fixed vs. Adjustable-Rate Mortgage (ARM): How They Work
How fixed-rate and adjustable-rate mortgages differ, how an ARM's index, margin and rate caps work, and a worked example of 2/2/5 caps, from CFPB guidance.
- A fixed-rate mortgage keeps the same interest rate for the whole loan, so principal and interest payments don't change.
- An adjustable-rate mortgage (ARM) has an initial rate for a set period, then adjusts periodically.
- After the initial period, the new rate is index + margin, limited by the loan's rate caps.
- The margin is set in your loan agreement and doesn't change after closing.
- Common caps: 2 or 5 points at the first change, 1 or 2 points at later changes, and 5 points over the life of the loan.
Side by side
| Fixed-rate | Adjustable-rate (ARM) | |
|---|---|---|
| Interest rate | Same for the life of the loan | Initial rate for a set period, then changes |
| Principal and interest payment | Doesn't change | Can go up or down after the initial period |
| What sets later rates | Nothing; set at closing | Index + margin, within caps |
| Main risk | Rates fall and you keep the higher rate unless you refinance | Rates rise and your payment rises |
| Where to see the terms | Loan Estimate | Loan Estimate, including the most the payment can be |
Property taxes and insurance collected in escrow can change with either type.
How an ARM adjusts
- Initial rate: applies for the first few years.
- Index: a market interest rate chosen by the lender when you apply. It generally won't change after closing.
- Margin: the percentage points the lender adds to the index. It's set in your loan agreement and can vary a lot between lenders.
- Fully indexed rate: index + margin. That's the new rate at each adjustment, unless a cap limits it.
- When the rate changes, the payment is recalculated so the remaining balance is paid off over the remaining term.
Rate caps
| Cap | What it limits | Common size (CFPB) |
|---|---|---|
| Initial adjustment cap | How far the rate can move the first time it adjusts | 2 or 5 percentage points |
| Subsequent adjustment cap | How far it can move at each later adjustment | 1 or 2 percentage points |
| Lifetime cap | How far it can ever move from the initial rate | 5 percentage points (some loans higher) |
Caps are often written as three numbers, such as 2/2/5. Some loans also have a floor, a limit on how low the rate can go. The CFPB suggests asking the lender for the highest payment you could ever have; the Loan Estimate shows it.
Worked example: caps in action
A $300,000, 30-year ARM starts at 5.5% with 2/2/5 caps and yearly changes after year 5. If index + margin were high enough each time, the most the rate could be is:
| When | Highest possible rate | Why |
|---|---|---|
| Years 1-5 | 5.5% | Initial period |
| Year 6 | 7.5% | First change limited to +2 |
| Year 7 | 9.5% | Later changes limited to +2 |
| Year 8 on | 10.5% | Lifetime cap: 5.5% + 5 |
These are the cap limits, not a guess about rates. To see payments for your own loan and rates, use the fixed vs. ARM payment calculator.
Reading ARM names
Hybrid ARMs are usually named by two numbers: the first is how many years the initial rate lasts, the second how often it adjusts after that. Check the loan documents for the exact adjustment schedule, index and caps, since names alone don't include them.
Questions to think through
- How long do you expect to keep this loan compared with the initial period?
- Could your budget handle the highest payment the caps allow?
- Which index does the ARM use, and what is the margin?
- Is there a prepayment penalty, or would refinancing be possible if rates change?
This guide defines the two loan types. It doesn't recommend either one or any lender. For loan programs, see mortgage loan types.
Frequently asked questions
What is the difference between a fixed-rate and an adjustable-rate mortgage?
A fixed-rate mortgage keeps the same interest rate for the life of the loan. An ARM has an initial rate for a set period, then adjusts based on an index plus a margin, within rate caps.
How is an ARM's new rate figured?
Index plus margin, subject to the loan's caps. The margin is set in your loan agreement and doesn't change after closing.
What does 2/2/5 mean on an ARM?
The rate can move up to 2 points at the first adjustment, up to 2 points at each later one, and no more than 5 points above or below the initial rate over the life of the loan.
Can an ARM payment go down?
Yes. If index plus margin falls, the rate can drop, subject to the caps and any floor in the loan.
Where can I see the most my ARM payment could be?
On your Loan Estimate. The CFPB also suggests asking the lender for the highest payment you could ever have.
Sources (Checked November 2026)
Free education only. Not tax, legal, investment or retirement-planning advice, and not a recommendation to open, fund, buy, sell or hold any account, investment or product. Enhance Finance LLC does not sell investments or financial products. Rules change, so confirm with the official source linked on this page (such as the IRS, the Social Security Administration, the CT Department of Revenue Services or the NC Department of Revenue) before you act, and ask a tax professional about your own situation.
Want your mortgage interest, points and property taxes handled correctly on your return?
Or call (475) 242-7941. Services are priced by quote.
Enhance Finance LLC · Andrew Nocera, Tax Preparer & Small-Business Finance Consultant. Based in Connecticut and working with North Carolina clients remotely.
Not tax, legal or investment advice. Figures are estimates for education. Checked November 2026.