What is an ARM?
With an Adjustable Rate Mortgage, or ARM, the interest rate and monthly payments can change as interest rates change. The rate is fixed initially and is subject to being resent based on changes in some interest rate benchmark. The big benefit to the borrower is that usually ARMs have interest rates (at least initially) that are lower than the rates on fixed mortgages. Sometimes it can even be 1 ½ to 2 ½ percent less.
There are several features of ARMs that you should evaluate if you are considering this type of mortgage.
Initial Rate. Be careful if the initial rate seems exceptionally low. It could be a “teaser” rate that only lasts for a short time and then the rate is adjusted upward. At a minimum, ask what the rate would be adjusted to if the initial rate ended today.
“Benchmark rate” where the ARM is tied. ARM rates are usually tied to some “published” index that reflects the general interest rate market. Usually the ARM rate is adjusted to that benchmark plus some level of margin. Ask the lender how this works and try to get an understanding of how the benchmark rate has changed recently.
The Cap. Most ARM’s have limits on how much the rate can rise in any one year and some ARM’s have a limit to what the rate can rise over the course of the mortgage. Understanding how the caps work will let you know “how bad it can get” if rates rise substantially.
Length of the rate periods. When you look at ARM’s you may find there are terms like 10/1, 7/2, 4/1 and the like. These refer to how long the initial rate lasts and how often the rate is adjusted after that.
Adjustable rate mortgages are attractive because of their lower initial rate. Your risk is that your rate and monthly payment will rise in the future. If you are comfortable and can accept an increased payment or you think you will be moving in a relatively short time, the savings with an ARM can be substantial.
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