Adjustable-Rate Mortgages: The Teaser That Resets
The rate on the billboard is the teaser
Shop for a mortgage and you’ll see two kinds of rate side by side. The fixed rate is higher, but it never moves: one payment for the whole 30 years. The adjustable rate is lower — sometimes a lot lower — and that’s the one the ads love to quote. The catch is in the word adjustable: that low rate is a teaser, fixed only for an intro period. After that, it resets.
An ARM is named by two numbers. A 5/1 ARM holds the teaser fixed for 5 years, then adjusts once a year after that. A 7/1 holds it seven years; a 10/1, ten. The first number is how long you get the discount; the second is how often the rate can change once the discount ends.
A fixed rate is a price. An ARM’s teaser is a sale — and like any sale, it ends.
Where the new rate comes from
When an ARM adjusts, the new rate isn’t arbitrary. It’s a published index (a market interest rate) plus a fixed margin the lender set in your contract. Together they’re the fully-indexed rate — the rate your loan is always trying to reach once the teaser expires.
It can’t get there in one leap, though. Every ARM has caps that limit each move. A common 2/2/5 structure means:
- the first adjustment can change the rate by at most 2 points,
- each later adjustment by at most 2 points, and
- the rate can never rise more than 5 points above where it started (the lifetime cap).
So a 5% teaser chasing an 8% fully-indexed rate doesn’t jump to 8% — it steps 5 → 7 → 8 over two years, each step capped. If the index spikes to 12%, the lifetime cap still pins your rate at 10%. Caps are the guardrail; they soften the blow but don’t remove it.
The reset re-amortizes your payment
Here’s the part that surprises people: when the rate changes, your payment changes too — and not in proportion. At each reset the loan re-amortizes. The lender takes your remaining balance, spreads it over the remaining term at the new rate, and that becomes your new payment. A rate that climbs from 5% to 7% can lift the payment by hundreds of dollars a month, because every dollar of the still-large balance now costs more interest.
This is the same amortization machinery from loan amortization — just recomputed each time the rate moves.
Watch a low payment jump above the fixed loan
The simulator races an ARM against the fixed-rate loan you could take instead, on the same loan amount and term. The flat dashed line is the fixed payment. The teal staircase is the ARM: low and level through the teaser, then stepping up at each reset toward the fully-indexed rate.
The shaded gap tells the story. Where the ARM line sits below the fixed line, you’re saving — that’s the teal “cheaper than fixed” region during the intro years. Where it climbs above, you’re paying more than the fixed loan would have cost — the amber reset bite. The “Savings eaten by” card is the hidden break-even: the month the ARM’s running total finally overtakes the fixed loan’s. Keep the loan past that point and the gamble has cost you money.
Things worth trying
- Drag “Rate it resets toward” up to 11–12%. The reset bite gets brutal — the lifetime cap is the only thing stopping it, and the worst-case payment leaps. This is the scenario that hurt borrowers who took ARMs before rates rose.
- Pull it back down to the teaser. Now the index never climbs, the payment never rises above fixed, and the “Savings eaten by” card reads Never — the ARM was simply the cheaper loan. The trouble is you don’t get to choose where rates go.
- Shorten the intro period to 3/1. You get less time at the discount and the reset arrives sooner — a riskier bet. Stretch it to 10/1 and you bank the savings far longer before any reset.
- Lower the comparable fixed rate. The closer fixed is to the teaser, the smaller the up-front saving — and the faster an upward reset eats it.
An ARM is a bet you’ll be gone
The whole case for an ARM rests on a single question — the same one that decides discount points and renting versus buying: how long will you keep this loan?
If you’re confident you’ll sell or refinance before the reset — a short posting, a starter home, a plan to move in a few years — you pocket the teaser discount and walk away before the bite. The ARM wins. But “I’ll refinance before it resets” is a bet on two things you don’t control: that you’ll still want to move, and that rates (or your finances) will let you refinance on good terms. If you’re still holding the loan when the teaser ends, the reset is not optional.
A fixed rate buys certainty. An ARM trades that certainty for a discount today — and hands you the interest-rate risk in return.
When an ARM makes sense — and when it doesn’t
- It can make sense if your intro period comfortably outlasts how long you’ll keep the loan, if you could still afford the worst-case capped payment (not just the teaser), or if you genuinely expect rates to fall.
- It’s a trap if you’re stretching to afford the teaser payment, if you “need” the low rate just to qualify, or if you’re quietly counting on refinancing to save you. That’s borrowing tomorrow’s risk to afford today’s house.
The fixed-vs-ARM choice is the same lever as every other mortgage decision: trading up-front cost, monthly payment, and risk against how long you’ll actually keep the loan.
Key terms
- Teaser rate — the low introductory rate an ARM is fixed at for its intro period, before the first reset. The rate on the billboard.
- Fully-indexed rate — the rate the loan resets toward: a market index plus the lender’s fixed margin. Where the rate is headed once the teaser ends.
- Rate caps (e.g. 2/2/5) — limits on how much the rate can move: the first adjustment, each later adjustment, and the lifetime maximum above the starting rate.
- Re-amortize — recompute the payment by spreading the remaining balance over the remaining term at the new rate. Why a higher rate means a higher payment.
- Reset / adjustment — the moment the ARM’s rate changes after the intro period, on the schedule the second number names (yearly for a 5/1).
A fixed rate is a price you lock; an ARM’s teaser is a discount that expires. The discount is real, but so is the reset — and an ARM only comes out ahead if you collect the savings and get out before the payment jumps. The rate you sign is the teaser, not the loan.