Adjustable-rate mortgages (ARMs) have been making something of a comeback lately. Although they've been out of favor in recent years, the rise in mortgage rates over the past year has some borrowers looking at them again as a way of minimizing their mortgage payments.

Initial rates on five-year ARMs have been running about 1.25 percentage points below that of comparable 30-year fixed-rate mortgages this year, according to Freddie Mac data, so the potential savings are significant.

Unfortunately, there's a lot of misunderstanding surrounding ARMs. Here's a quick rundown of the key things to know about them.

1 - They aren't "exotic" or "toxic"

This is the first thing you need to know. ARMs are actually a very traditional, mainstream type of loan. In many countries, they're the main type of mortgage used to buy a home. Their key feature is that their interest rate varies, or adjusts, over time to reflect current market rates, rather than being locked in to a single rate for the life of the loan.

ARMs got a bad reputation during the housing bubble because they often came loaded with features that made it easy for borrowers to get into financial trouble - things like artificially low teaser rates that disguised the true cost of the loan. Fortunately, those "toxic" features have virtually disappeared from the market.

A "plain vanilla" ARM will offer you a fixed-rate for a certain length of time - usually 3, 5, 7 or 10 years - and then readjust to a new, market-based rate every year after that. That's why such loans are referred to as 3/1, 5/1, 7/1 or 10/1 ARMs, for example - the first number is the length of time the initial rate is fixed, and the second is how often the rate resets after that. Not all ARMs reset every year - you might get a 7/2 ARM, for example, although annual adjustments are the most common.

2 - They're great for short-term owners

ARMs are an ideal loan product for people who don't expect to stay in a home for an extended period of time. The typical home is resold about every seven years - meaning the owner has moved on. If your plans call for moving up to a nicer home in a few years, or you expect to relocate for business reasons, or if you're buying a house with the intention of fixing it up and flipping it, an ARM is a great product. Why pay a premium to lock in a mortgage rate for 30 years if you're only going to own the property for five?

They're also a good product at times when trends suggest that mortgage rates will decline over the coming years, because ARMs can adjust downward as well as up. But with rates as low as they are right now, few people expect that to happen. But at times when rates are running above their historic norms, as they were in the 1980s, ARMs can be a pretty good choice for long-term homeowners as well.

However, if you're buying what you intend to be your permanent home, a fixed-rate mortgage is probably your better choice. With rates still unusually low by historic standards, those who anticipate owning their homes for more than 10 years will likely benefit by locking in today's rates for the long haul.

3 - Rate increases are limited

A lot of borrowers are concerned that if they get an ARM, the rate may eventually spiral out of control once it starts adjusting. That's a real concern, particularly if you end up owning the home longer than you expect.

Fortunately, rate increases on ARMs are capped. First, there's a limit on how much your rate can increase each time it adjusts. Second, many ARMs also include a lifetime cap on just how high the rate can go. So even if you pay the loan off over 30 years, the rate will never go higher than that lifetime cap. Both of these must be disclosed in the HUD-1 Settlement Statement provided to you before closing the loan.

During the early 2000s, many ARMs were set up to allow or practically require large increases in the interest rate as soon as it started to adjust, which is how many borrowers got in financial difficulty. So keeping a close eye on those adjustment caps is critical when getting an ARM.

4 - Understanding the margin

When an ARM adjusts, the new rate is based upon a rate index that reflects current lending conditions. The new rate will be the index rate plus a certain margin established at the time you took out the loan. So if the index is at 3.5 percent when your rate readjusts and your margin is 2 percent, your new rate will be 5.5 percent.

That's assuming that your rate caps, described above, allow such an adjustment. If your original rate was 3.25 percent, and your adjustment cap was 2 percent, your first adjustment can't go higher than 5.25 percent, no matter what the index does.

Some of the most commonly used rate indexes for ARMs are one-year Treasury securities, the London Interbank Offered Rate (LIBOR) and the Cost of Funds Index (COFI). Some lenders may use their own proprietary index. In any event, the index to be used it is disclosed as part of originating the loan and remains in force for the life of the loan.

5- What about those toxic features?

To be sure, many people are still uncomfortable with the notion of ARMs, given what was going on a decade ago. And it is possible you could still encounter ARMs with so-called "exotic" features - it's just that you're not likely to run into them these days unless you're a sophisticated borrower seeking a high-value loan from a specialty lender.

In fact, most of the things that made certain loans toxic during the bubble are now prohibited in mortgages backed by Fannie Mae, Freddie Mac, the FHA or VA - which account for nearly all middle-class mortgages in this country. But to be on the safe side, here are some of the things to look out for if you find them in an ARM offered to you:

Teaser rate: A low initial rate that can climb above market rates for ARMs when it resets. Here's a test: check the loan's adjustment margin and add it to the current rate of the designated index. If that produces a rate that's notably higher than the initial rate other lenders are offering you, it's likely a teaser rate.

Interest-only loans: When your loan payments during the fixed-rate period only cover interest and do not make any progress on paying down principle. When principle gets thrown into the mix after the first adjustment, the loan can easily become unaffordable. This is a popular feature for sophisticated borrowers who don't want their money tied up in a mortgage, but can be deadly for the average consumer.

Negative amortization: Like an interest-only loan, except that your payments don't even keep up with the interest charges, so that your loan balance grows over time. Also popular with sophisticated borrowers, but not a good choice for the average person.

Pre-payment penalties: This is a charge incurred if you pay the loan off early - not just before the rate adjusts, but potentiallly any time during the scheduled amortization of the loan (usually 30 years). Since that's what happens if you sell the home or refinance the mortgage before the rate resets, having to pay a penalty could wipe out much of the advantage of having an ARM in the first place. Unless you're taking out a "no closing cost" loan, where the closing costs are actually paid through a higher interest rate, you shouldn't have to accept a pre-payment penalty on any mortgage.

Again, ARMs aren't for everybody. But for certain homebuyers - particularly those expecting to move again in a few years - they're a great product. If you're a regular homebuyer seeking a conventional mortgage from a mainstream lender or credit union, you owe it to yourself to at least check them out.

Published on June 2, 2012