ARM's-length: the awkward truth about APRs on adjustable-rate mortgages

Two forces are at play. First, APR is designed to be a "total" cost of credit: it rolls in the note rate and most fees, spread over the assumed life of the loan. That alone makes APR higher than the advertised rate. Second, ARMs complicate matters. After the initial fixed period—usually three, five, seven or ten years—the rate resets to an index (these days usually SOFR) plus a margin, subject to caps. Regulators require that lenders compute APRs on the assumption that the loan will remain outstanding to maturity and that the fully indexed rate after the teaser will persist. In today's high-rate environment, that math makes the APR look forbidding.

Why the APR looks so steep

Under the Truth in Lending rules, lenders must calculate a composite APR for multi-rate loans. They take the initial rate during its fixed period, then switch to the fully indexed rate for the rest of the 30-year term, folding in fees as well. If the index plus margin is well above the teaser, the APR leaps. That's why an ARM can look like a wolf in sheep's clothing even when the initial payments are modest.

There is also a regulatory wrinkle. If the APR sits too far above benchmark rates, the loan may be classed as "higher-priced," triggering extra scrutiny and escrow requirements. For borrowers, that can mean more paperwork and less flexibility.

When the scary APR matters less

APR is excellent for comparing loans you intend to keep for decades. But few Americans do. Refinancing is endemic: in late 2024, the average rate-and-term refinancer had held their loan for barely 15 months. When borrowers rarely keep a mortgage beyond five to seven years, an APR based on 30 years of payments is a poor guide.

For ARMs, this mismatch is even starker. The APR calculation assumes you will endure years of floating rates after the fixed period ends. In reality, most borrowers either move or refinance long before then. Regulators themselves caution that APRs on ARMs are not good predictors of future cost and are tricky to compare.

How to shop an ARM sensibly

A sensible borrower should look at four things:

A prudent approach

Run two scenarios: one where you refinance or sell before the first reset, and another where you cannot and must absorb the adjustment. The first tells you the likely savings; the second tests whether you can survive the worst case. If both outcomes are tolerable, you have found your comfort zone.

So, should you fear the ARM APR?

Not necessarily. The APR looks frightening because the rulebook assumes a 30-year marriage at today's rates and spreads costs over decades. In reality, many borrowers part ways quickly, thanks to moves, life changes or falling interest rates. For those who will plausibly refinance within the fixed window, the initial rate, fees and caps matter far more than the APR.

Treat the APR on an ARM less as a prophecy and more as a warning label. It tells you what could happen in theory, not what will happen in practice. For most borrowers, the real question is simpler: will you be out of this loan before the music changes?