What is an adjustable rate mortgage?

Adjustable Rate Mortgages (ARMs) Explained

Adjustable Rate Mortgages, ARMs for short, got a bad wrap during and after the credit crisis, because many borrowers felt that they were not informed nor educated about the product when they purchased an ARM. It is important to work with a patient loan officer who will take the time to understand your needs, and educate you on any loan that may fit your needs. Google and internet searches can help in your education as well. Simply make sure that you are using a trusted source to gather your information

What Is An Adjustable Rate Mortgage, an ARM?.

With an Adjustable Rate Mortgage, you can achieve a lower monthly payment, and still pay back the interest and principal from the beginning of the loan. An ARM has a fixed-rate for the first portion of the loan. Typically, for the first 5, 7, or 10 years of the ARM you will pay a fixed interest rate. At the end of the fixed-rate portion of the loan (5, 7, or 10 years), your interest rate will adjust. You will pay this interest rate for the rest of the loan term.

The initial interest rate is low because the lender does not have to factor in inflation for the entire life of the loan (typically 30 years). At the end of your 5, 7, or 10 years, the interest rate will adjust up or down once per year. This adjustment is dictated by market conditions.

In an ARM, when the interest rate adjusts after 5, 7, or 10 years, the lender will add a margin to an index. Different lenders use different interest rate indexes to calculate the adjusted rate. The most commonly used index is called LIBOR. This stands for London Inter-Bank Offered Rate. In basic terms, the LIBOR index is the average of the interest rates estimated by the leading banks in London that the banks would be charged to borrow money from each other.

What does this all mean for you? The lender will readjust their rate in an Adjustable Rate Mortgage also known as an ARM, based upon an index like LIBOR. The lender will add a profit margin to that index to calculate that rate, and the rate will adjust up or down once per year at a set date.

There is a cap on how much your interest rate is allowed to adjust up during each annual adjustment. So make sure you know exactly what the cap is, and factor this into your monthly payment calculations as a conservative "worst-case" scenario.

Keep in mind, you may have the ability to refinance from an ARM into a fixed rate mortgage if you decide this is the best option.

As you can see, ARMs can also make sense if you are looking to keep the house for 10 years or less.

ARMs have similar selling points and drawbacks to Interest-Only mortgages, however ARMs include the principal in your monthly payments throughout the entire life of the mortgage.

With an ARM, you also have the option to pay down the principal by making larger payments each month. If you choose to make larger payments, when your loan recalculates (re-amortizes) and your rates adjusts, you will have a lower monthly payment.