Adjustable-Rate Mortgages

Adjustable-rate mortgages (ARMs) are popular because they usually start with a lower interest rate and a lower monthly payment. However, the interest rate can change during the life of the loan.
It's important to understand the specifics of an adjustable-rate mortgage:

• Adjustment periods
  All ARMs have adjustment periods that determine when and how often the interest rate can change. There is an initial period during which the interest rate doesn't change – this period can range from as little as 6 months to as long as 10 years. After the initial period, most ARMs adjust the interest rate periodically.
• Indexes and margins
  At the end of the initial period and at every adjustment period, the interest rate can change based on two factors: the index and the margin. Interest rate adjustments are based on a published index. There are many indexes but some commonly used for ARMs are the London Interbank Offered Rate (LIBOR) and the U.S. Constant Maturity Treasury (CMT). Indexes reflect current financial market conditions, which is why your ARM interest rate can change at each adjustment period. The margin is the percentage that can be added to the index. Based on these two factors, the interest rate on your mortgage can increase or decrease. This will cause changes in your monthly payments. Remember, if the interest rate on your mortgage increases, your monthly payment will also increase.
• Caps, ceilings, and floors
  All ARMs have rate caps, also known as ceilings and floors. Caps decide how much the interest rate can increase or decrease at each adjustment period and over the life of your loan. For instance, a 10/1 ARM with a 5/2/5 cap structure means that for the first 10-years the rate is unchanged, but on the eleventh year (the date of first adjustment), your rate can increase by a maximum of 5 percent (the first "5") above the initial interest rate. Every year thereafter, your rate can adjust a maximum of 2% (as noted by the second number "2"). But, your interest rate can never increase more than 5 percent (the last number, "5") throughout the life of the loan.
• "Hybrid" ARMs
  This type of ARM has a fixed interest rate for a certain period of time and then the interest rate adjusts for the remainder of the loan, like a conventional ARM. There are several types of hybrid ARMs, such as the 10/1, 7/1, 5/1, and 3/1. The first number (10 for example) is the length of the initial period, during which the interest rate doesn't change. The second number (1 for example) is how often the ARM is adjusted after the initial period. So, the interest rate on a 10/1 ARM won't change for the first 10 years, but can change in the eleventh year and be adjusted every year after that up to a maximum amount.

There are additional considerations to be aware of with adjustable-rate mortgages:

• Because the initial interest rate is usually lower than a fixed-rate mortgage, you may qualify for a larger loan amount. If interest rates are high when you get your mortgage but drop during any adjustment period, your monthly payment may decrease. But a decrease is very unlikely, so don't base your choice of mortgage on this.
• An ARM with a low initial interest rate and an initial adjustment period after 5 or 7 years can save you money.
• ARMs can, and often do, have interest rate increases at adjustment periods. You may have an increase in your monthly mortgage expense after adjustment periods.