Adjustable Rate Mortgages

How do they work?

As you begin thinking about buying a home and shopping around for a mortgage, you're sure to come across adjustable rate mortgages. You might just avoid them or look past them—either because you find them confusing or because you've heard they can be problematic.

It is true that adjustable rate mortgages aren't always a smart choice. But sometimes, an ARM really is a wise way to finance your home purchase, and you won't know if it's right for you unless you understand what it is and how it works.

How do adjustable rate mortgages work?

You're probably most familiar with a fixed rate mortgage. With a fixed rate loan, you pay the same interest rate throughout the life of the mortgage; the rate is fixed. As the name suggests, the rate on an adjustable rate mortgage changes throughout the term.

How does the rate change? Well, that depends on the type of ARM you take out. There are several common types of ARMs, including the following:

5/1 ARM

This type of mortgage has a fixed interest rate for the first five years. Once five years have passed, the rate is adjusted once a year for the remainder of the loan period.

10/1 ARM

This is basically the same as a 5/1 ARM, but you get a fixed rate for the first 10 years, rather than the first five.

1/1 ARM

This type of mortgage has a fixed rate for the first year, and then the rate is adjusted annually. 

What is the common terminology used when discussing ARMs?

As you look at different ARMs from various lenders, there are some terms that you'll come across. Understanding what they mean will ensure you fully understand the terms of the loan you're being offered.

Initial Cap

This is the maximum amount by which your interest rate can change the first time it changes. For example, if you have an initial rate of 2% and a cap of 2%, your rate can only increase to 4% after the first adjustment.

Periodic Cap

This is the maximum that your rate can change in subsequent years. If your periodic cap is 2%, for example, you can never receive an annual adjustment above 2%.

Lifetime Cap

This is the maximum percentage by which your rate can increase over the initial rate. So if you have an initial rate of 2% and a lifetime cap of 5%, your interest rate is promised to never exceed 7% for the duration of your mortgage.

When should you consider an ARM?

Now that you understand how an ARM works and how rates adjust, how do you decide whether this type of mortgage is right for you? Typically, people choose an ARM when there is some reason why they would benefit from paying a lower interest rate. The benefit of paying that lower interest rate outweighs the uncertainly of the rate increases that follow.

Here are some common scenarios in which an ARM may work well:

• You only plan on living in a home for a couple of years and think you'll sell before the first adjustment.
• You have a low income, but expect it to increase significantly by the first adjustment. (Doctors in residency often buy with ARMs.)
• You need the lower interest rate to afford updates to the home and plan on refinancing once you make those updates.

An ARM is only a bad choice if you are unprepared for the rate increase that comes after the fixed period. If you understand how these loans work and have a good reason for choosing one, they can be a smart tool to power your home purchase.