What is an Adjustable Rate Mortgage (ARM)?

Adjustable Rate Mortgages Offer Flexibility

The stability of a conventional fixed-rate mortgage works beautifully for settled homeowners who value a predictable monthly payment. But an adjustable rate mortgage might be the right choice for you – especially if you are planning to move within five years.

How does an ARM work?

An adjustable rate mortgage is an alternative to a fixed-rate home loan. Typical advantages of ARMs include:

• Lower starting interest rate
• Lower starting monthly payment
• Ability to afford more house space
• Possible to pay less in return, in favorable market conditions

Homeowners with an ARM take advantage of an “introductory” interest rate set lower than that for conventional loans. The loan proceeds at this rate for an agreed-upon period of time, usually several years. Once the introductory period expires, the interest rate “resets” – moves up or down in line with the movement of an “index” (major interest rate). Following this movement, the amount of interest you pay each month gets larger or smaller.

Hybrid ARMs are signified by the fractions in their titles – 3/1, 5/1, 7/1, 10/1. The first digit tells you the number of years with the introductory rate. The second digit reveals the length of the adjustment period once it becomes a variable rate. For instance, on a 5/1 rate, the first reset takes place after five years. The next reset can take place one year later, and every 1 year after that, until the end of the loan.

Should I look at an ARM?

There are a number of borrowers well suited to an adjustable rate home loan. They are particularly good for people who think they will move during the introductory period – a starter home, a short-term job transfer, etc. ARM borrowers typically have some of the following characteristics:

• An income that can handle the maximum rate and monthly payment
• Steady upward movement of income reasonably expected over the coming years
• A low debt load that would not interfere with payments
• Short-term ownership

Recent changes to ARM loans protect borrowers who take this option. These home loans have an adjustment cap and a lifetime cap, which limit the amount that an interest rate can adjust – in one adjustment period and over the loan term, respectively. There are also a series of disclosures that the lender must make, such as maximum interest rate and payment. The successful ARM candidate studies all of this information and carefully considers how it applies to their own situation before making a sound decision.