ARMs are back in the conversation because the initial rate is typically 0.5-1.0% below a 30-year fixed. The question is never "is the ARM rate lower?" — it always is. The question is: does the rate savings during the initial fixed period outweigh the rate reset risk after year 5 or 7?
Worked example:$400,000 loan. 30-year fixed at 7.0% = $2,661/mo P&I. 7/1 ARM at 6.25% initial rate = $2,463/mo for first 84 months. Monthly savings during the fixed period: $198 × 84 = $16,632 saved. If you sell or refi before year 7, pure win. If you stay and the ARM resets to 9.0% (worst case), your P&I jumps to ~$3,150/mo — $489 more than the fixed would have been.
How ARMs actually adjust
A 5/1 ARM has a fixed rate for 60 months, then adjusts annually. 7/1, 10/1 same idea. The new rate equals an index (usually SOFR) plus a fixed margin (typically 2.25-2.75%), capped by three caps:
- Initial adjustment cap — max change at first reset, usually 2%.
- Periodic cap — max change per year after, usually 2%.
- Lifetime cap — max total change over original rate, usually 5%.
So a 7/1 ARM starting at 6.25% has a lifetime ceiling of 11.25%. In the worst case, your rate goes 6.25% → 8.25% → 10.25% → 11.25% over three years of adjustments, then holds at 11.25%.
When an ARM is the right call
- You have a confident exit before the reset. Military reassignments, contract work, planned moves for school or career, or you plan to sell when kids graduate.
- You expect rates to fall. Not a given — but if today's fixed rate is near a cyclical high, the ARM reset could be at a lower rate than today's fixed.
- You'll pay down principal aggressively. Lower rate + lower payment during fixed period = more headroom to attack principal. Entering year 8 with a much smaller balance dampens the reset.
- The spread is wide. Historically, a 0.75%+ spread between ARM and fixed makes the math attractive. Spreads under 0.5% usually favor the fixed.
When a fixed is the right call
- You plan to stay 10+ years and sleep better knowing the payment is locked.
- You are stretching on affordability — any rate reset would tip you into distress.
- You have variable income (commission, self-employed, stock vesting) — do not stack payment volatility on top of income volatility.
- The ARM spread is under 0.5%. Not worth the tail risk.
The 'refi when it resets' fallacy
The standard ARM pitch is "you can always refinance before the reset." Sometimes true, sometimes disastrous. In 2021, everyone refinanced. In 2023, the refi window closed overnight. If the reason rates are low at reset is that the economy is fine, great — refi. If rates are still high at reset (because the Fed is still fighting inflation), you are stuck. ARM buyers in 2005-2007 found this out the hard way. Always model the ARM as if you cannot refinance. If the worst case is livable, it is a real option. If it is not livable, choose the fixed.