Adjustable Rate Mortgages (ARMs) have lower initial interest rates, which can help qualify you for a larger loan amount and reduce your monthly payments.
IMPORTANT NOTE: The initial lower rate is usually just temporary, and will eventually adjust to the market rate.
Let's look at features shared by all ARMs:
- Lower initial rates. Your starting rate on these mortgages is, for the most part, one to four percentage points below those on a conventional 30-year mortgage.
- An adjustment period. This is the amount of time before your mortgage rate adjusts to the market. For example, a one-year ARM means that your interest rate adjusts to the market rate every year on a pre-set anniversary date. A three-year ARM will adjust three years after you take out the loan and then every third year thereafter.
- A margin and index. The margin is the amount over the index that your rate will be set at. For example, if the margin is 2% and the index is 2%, your interest rate will be 4% (2% plus 2 points). The index is a published national rate, most frequently the current interest rates being paid on short term U.S. Treasury securities.
- A cap. This is the amount that cannot be exceeded during any one adjustment period. For example, if your cap is two points (the most common) and your new rate will be three points higher than your current rate at an adjustment date, the maximum your rate would go up is two points (the cap), not the calculated three-point increase.
SUGGESTION: ARMs may make the most sense for those who relocate frequently. Since initial rates are lower than those available with a fixed-rate mortgage, you may be moving before the mortgage gets a chance to adjust.
A feature common to some ARMs is the ability to convert to a fixed rate mortgage at some future point in time. Expect to pay for such a feature in the form of a higher rate, a fee up front, or a fee at the time of conversion. This payment may be worth it. If you take out an ARM, get the benefit of lower initial rates, and when interest rates come down, you can lock in at the lower rate. You get the best of both worlds—a cheaper initial mortgage followed by the predictability of a fixed rate later.