Adjustable Rate Mortgages

How to Decide if an ARM Is Right for You

An adjustable rate mortgage, called an ARM, is a mortgage with an interest rate that is connected to an index. The interest rate and your payments are periodically adjusted up or down as the index changes.
An index is a guide that lenders use to measure interest rate changes. Common indexes used by lenders include the activity of one, three, and five-year Treasury securities, but there are many others. Each ARM is connected to a specific index.

Margin
Think of the margin as the lender's markup. It is an interest rate that represents the lender's cost of doing business plus the profit they will make on the loan. The margin is added to the index rate to determine your total interest rate. It usually stays the same during the life of your home loan.

Adjustment Period
The adjustment period is the period between potential interest rate adjustments.
You may see an ARM described with figures such as 1-1, 3-1, and 5-1. The first figure in each set refers to the initial period of the loan, during which your interest rate will stay the same as it was on the day you signed your loan papers.

The second number is the adjustment period, showing how often adjustments can be made to the rate after the initial period has ended. The examples above are all ARMs with annual adjustments - meaning adjustments could happen every year.

The initial interest rate for an ARM is lower than that of a fixed rate mortgage, where the interest rate remains the same during the life of the loan. A lower rate might help you qualify for a larger loan.
How long do you plan to own the house? The possibility of rate increases isn't as much of a factor if you plan to sell the home within a few years.
Do you expect your income to increase? If so, the extra funds might cover the higher payments that result from rate increases.

Some ARMs can be converted to a fixed rate mortgage. However, conversion fees could be high enough to take away all of the savings you saw with the initial lower rate.

We can explain how each index used has performed in the past. Your goal is to find an ARM that is connected to an index that has remained fairly stable over many years.

Rate caps limit how much interest you can be charged. There are two types of interest rate caps associated with ARMs.

• Periodic caps limit the amount your interest rate can increase from one adjustment period to the next. Not all ARMs have periodic rate caps.
• Overall caps limit how much the interest rate can increase over the life of the loan. Overall caps have been required by law since 1987.
  
  

A payment cap limits how much your monthly payment can increase at each adjustment. ARMs with payment caps often do not have periodic rate caps. If an interest rate cap held your interest down at an adjustment even though the index went up, the amount of the increase can be carried over to the next adjustment period.