How does an adjustable-rate mortgage (ARM) typically work, and what does a '5/1 ARM' mean?

A 5/1 ARM has a fixed interest rate for the first five years, after which it adjusts annually. The new rate is calculated by adding the lender's margin (typically 2% to 3%) to a benchmark index such as the Secured Overnight Financing Rate (SOFR). ARMs have periodic caps (limiting how much the rate can change per adjustment, often 2%) and lifetime caps (limiting the total change over the life of the loan, often 5% to 6% above the initial rate). ARMs can be advantageous for buyers who plan to sell or refinance before the fixed period ends, but carry risk if rates rise significantly after adjustment begins.