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Adjustable-Rate Mortgages

Interest rates for adjustable-rate mortgages vary over time

The interest rate with an adjustable-rate mortgage (ARM) varies over time. The initial interest rate on an ARM is set below the market rate on a comparable fixed-rate loan. The rate rises as time goes on. If the ARM is held for a long enough term, the interest rate will surpass the going rate for fixed-rate loans.

In ARMs the initial interest rate remains constant during a fixed period of time. After that time the interest rate adjusts at a pre-arranged frequency. A fixed-rate period can vary – anywhere from one month to 10 years. Shorter adjustment periods typically carry lower initial interest rates.

ARM Terminology

Because ARMS are significantly more complicated than fixed-rate loans here are some basic terminology borrowers should understand before selecting an ARM for themselves.

  •  Adjustment frequency refers to the amount of time between interest-rate adjustments (e.g. monthly, yearly, etc.).
  • Interest-rate adjustments are tied to a specific indexsuch as the interest rate on certificates of deposit, Treasury bills or the LIBOR rate. These are called Adjustment Indexes.
  • Signing your loan means you agree to pay a rate that is a certain percentage higher than the adjustment index. The adjustable rate may be the rate of the one-year T-bill plus 2%. That extra 2% is called the margin.
  • Caps are limits on the amount the interest rate that can increase each adjustment period.
  • The highest interest rate that the adjustable rate is allowed to become during the life of the loan is called a ceiling.

ARMs offer low initial payments and enable the borrower to qualify for a larger loan. In a falling interest rate environment they allow the borrower to enjoy lower interest rates without the need to refinance.

But your monthly payment may change frequently over the life of the loan. If you take on a large loan, you could run the risk of some trouble when interest rates rise.

When choosing a mortgage, you should consider your own circumstances as well as the realities of an ever-changing marketplace.

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