Adjustable-Rate Mortgages: Know the Basics

Gravity has taught us that what goes up must come down. The same can be said for adjustable rate mortgages (ARMs)which generally begin with lower interest rates than fixed-rate mortgages, and adjust periodically. Adjustable mortgage rates are tied to an index, such as the prime rate, and they fluctuate according to the index rate.

ARMs as hybrids

Today, many ARMs are actually hybrid loans, with a low initial fixed-interest rate that switches to an adjustable rate on a pre-determined date.

Hybrids are usually listed as 3/1, 5/1, 7/1, or 10/1 loans. The first figure (the "3" in 3/1) is the number of years that the interest rate is fixed at the low starting rate. The second number (the "1") is the number of years between rate adjustments. With a 5/1 loan, the lender will collect the initial interest rate for five years, then adjust the mortgage loan rate annually to reflect changes in the market.

If your cash flow is tight, a lender may prefer to offer you an ARM, which has an initial payment better suited to your budget. You may prefer it, as well, because the monthly payment will be lower than a comparable fixed-rate mortgage.

Caps

Even if you remain in your home after the interest has become adjustable, your rate will not rise forever. It will be capped, either during the life of the loan, annually or monthly. In addition, it will never rise above that figure. Before you accept this type of mortgage, it's crucial to understand how and when the rates are capped. If you opt for an ARM that's not a hybrid, you may be hit with unpleasant surprises if interest rates keep rising.

ARMs can provide considerable savings for the first few years that you're in your new home. The lower monthly payments may also help you finance a home that you may not be able to afford with a fixed-rate mortgage. If interest rates are rising, however, ARMs may defy gravity and keep going up. However, if you understand how your mortgage works, you'll avoid being hit by any unpleasant surprises.