With an adjustable-rate mortgage (ARM), the interest rate you pay is adjusted from time to time to keep it in line with changing market rates. When interest rates go down, so might your mortgage payments; but keep in mind that your payments could go up when interest rates are raised.
ARMs are attractive because they may initially offer a lower interest rate than fixed-rate mortgages. Since the monthly payments on an ARM start out lower than those of a fixed-rate mortgage of the same amount, you can qualify for a larger loan. The chief drawback, of course, is that your monthly payments may increase when interest rates rise.
You may want to consider an ARM if:
- You are confident your income will rise enough in the coming years to comfortably handle any increase in payments
- You plan to move in a few years and therefore are not so concerned about possible interest rate increases or
- You need a lower initial rate to afford to buy the home you want
An ARM has two "caps" or limits on how large an interest rate increase is permitted. One cap sets the most that your interest rate can go up during each adjustment period, and the other cap sets the maximum total amount of all interest adjustments over the life of the loan.
For example, a typical ARM that adjusts annually may have a yearly cap of 2%, meaning that the adjusted interest rate can never be more than 2% higher than the previous year. And such an ARM may have a lifetime rate cap of 6%, meaning that the interest rate on your loan will never be more than 6% over the original rate. So, if you are looking at an ARM with a current introductory rate of 5%, a lifetime cap of 6% tells you that the highest interest rate you could ever pay would be 11%.
TIP: Before applying for an ARM, be sure you know how high your monthly payments could go - the "worst-case scenario." Only you can determine if you would feel comfortable paying this interest rate sometime in the future.
Your lender can tell you which ARMs offer a conversion feature that allows you to convert from an adjustable rate to a fixed rate at certain times during the life of your loan.
One important thing to know when comparing ARMs is that the interest rate changes on an ARM are always tied to a financial index. A financial index is a published number or percentage, such as the average interest rate or yield on Treasury bills.
The following are the most common types of ARMs:
- CD-Indexed ARMs (Certificate of Deposit): After an initial six-month period, the initial rate and payments adjust every six months. These ARMs typically come with a per-adjustment cap of 1% and a lifetime rate cap of 6%.
- Treasury-Indexed ARMs: These are tied to the weekly average yield of U.S. Treasury Securities adjusted to a constant maturity of six months, one year, or three years. Likewise, the interest rate on your ARM will adjust once every six months, once each year, or once every three years, depending on the schedule you choose. Per-adjustment caps and lifetime rate caps also vary.
- Cost of Funds-Indexed ARMs: Indexed to the actual costs that a particular group of institutions pays to borrow money, the most popular of this type is the COFi for the 11th Federal Home Loan Bank District. COFi ARMs can adjust every month, every six months, or every year, and the per-adjustment caps and lifetime rate caps vary.
- LIBOR-Based ARMs: The London Interbank Offered Rate is the interest rate at which international banks lend and borrow funds in the London Interbank market. The six-month LIBOR ARM typically has a per-adjustment period cap of 1% and is offered with either a 5% or a 6% lifetime rate cap.
- Initial Fixed-Period ARMs: As protection against rapid interest rate increases in the early years of your loan, interest rates for these ARMs don't adjust until several years after you take out the loan. You can choose from three, five, seven, or 10-year fixed terms. At the end of your chosen fixed-rate period, your interest rate would adjust every year.
- Two-Step Mortgage®: This special type of ARM provides the benefit of initial low rates with the stability of longer term financing because it adjusts only once - either at seven years or at five years. After that initial adjustment, the mortgage maintains a fixed rate for the remaining 23 or 25 years of a 30-year mortgage repayment term. For example, if your initial interest rate were 8%, you would pay that rate for the first seven (or five) years. Then, for the remaining 23 (or 25) years, you would pay an interest rate that is indexed to the value of the 10-year U.S. Treasury security on the adjustment date. (At the adjustment date, there is no additional refinancing cost, no forms to complete, and no re-qualification necessary.) This new rate can never be more than 6 percentage points higher than your old rate. There are no limits on how much lower the adjusted interest rate can be.
