Adjustable Rate Mortgages

An Adjustable Rate Mortgage (ARM) has a variable interest rate component, which means the interest rate will change during the life of the loan. An ARM might be a tempting choice over a fixed rate mortgage because the starting interest rate is often lower than a Fixed Rate mortgage.

Before determining which type of home loan to choose, try to envision how long you will stay in this home before selling it. If you plan on moving up to a larger home after 5 years, you can consider a 5-year ARM. A 5-year ARM is fixed at the beginning interest rate for 5 years. After 5 years, your lender will be able to change your interest rate to match a benchmark rate (see the Index discussion later on in this article) plus a markup value, called a Margin. Often you'll have your choice between different fixed rate periods - also common are 3-year ARMs and 7-year ARMs.

If you are considering a loan where the interest rate adjusts (an ARM, or Adjustable Rate Mortgage), make sure you ask these questions of your mortgage broker:

How long is the mortgage interest rate fixed?

A "3 year Fixed ARM" or a "3/1 ARM" usually means that the interest rate will be fixed for 3 years. After that the interest rates will adjust yearly according to the index it follows.

Let's say you are comparing two adjustable rate mortgages on a $200,000 loan. One is an ARM where the interest rate is fixed for 1 year and may change every year after that, and the other loan is an ARM which is fixed for 5 years (often written as 5/1). Let's say you think you'll live in your home for the next 5 years. The following table shows payments for both loans:

In this example, you pay less with the 5 year arm by about $10,000 in 5 years, and you managed to repay more principal, even though the first year's payment for the 1 year ARM was less by about $80 dollars each month. It's really a guessing game, though. Will rates continue to rise at 1% yearly? The 5 year ARM gives you some security, with a steady monthly payment.

How often can the interest rate change and how much?

Find out how long the fixed rate period is, how often the interest rate will be adjusted, and the maximum amount it can change each adjustment period (sometimes called the periodic adjustment cap).  Often you can determine the adjustment period by the name of the loan. For example, a 5/1 ARM is a 5-year fixed rate loan with adjustments every year after that. Most ARMs adjust every year.

How much will my index rate increase after the fixed period?

Though no one knows what interest rates will be in 3-5 years, at least you can make some guesses as to what your interest payment might be based on average interest rates. In order to make this determination, find out 2 things from your lender: the Index the mortgage follows and the Margin, which is the markup over the index rate. Lenders often use the London Interbank Offered Rate (LIBOR), but may use other indexes. Some indexes are more volatile than others, so when comparing, ask your lender for a chart of the index over the years to compare to another loan that may have a different index. Lenders add the index rate to the margin to get your interest rate after the initial fixed period. For example, if the Index is 3% and the margin is 3%, your interest rate will be 6%.

What is the lifetime interest rate cap? 

If interest rates go through the roof, what is the maximum amount your interest rate will increase? This cap protects you from an extreme circumstance where interest rates get outrageously high.

Unfortunately, many of us start our first home search with no idea how lending works, but that is no excuse to close your eyes when you sign loan papers for a home. Make sure you understand the details of your adjustable rate mortgage, which must be spelled out by your lender in detail.

Copyright © 2006 by Liz Suto. Liz Suto is a professional writer, North Phoenix real estate agent and Anthem Arizona resident.