Adjustable-Rate Mortgages (ARMs)
Are they for me? Features, Benefits, and Risks


ARM: Description

Adjustable-Rate Mortgages (ARMs) are home loans that have an interest rate that changes periodically (unlike fixed-rate mortgages, which have an interest rate that remains the same for the life of the loan).

ARM: Benefits and Risks

Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages, which makes the ARM easier on your pocketbook at first than a fixed-rate mortgage for the same amount. It also means that you might qualify for a larger loan because lenders sometimes make the decision about whether to extend a loan on the basis of your current income and the first year's payments. If interest rates remain steady or move lower, your ARM could be less expensive over a long period than a fixed-rate mortgage.

Weighed against these benefits, you assume the risk that interest rates will increase and result in higher monthly payments after your initial interest rate period has expired. It is a trade-off – you get a lower rate with an ARM in exchange for assuming more risk.

ARM: Features

An ARM has four key features:

  1. Index
  2. Margin
  3. Initial interest rate period
  4. Interest rate cap structure

When the initial interest rate period has expired, the new interest rate is calculated by adding a margin to the index. Your lender will disclose the margin at time of loan application (margins may vary from lender to lender, so it is a good idea to shop around for a low margin). As the index figure moves up or down, your interest rate will be adjusted accordingly.

Increases or decreases in the interest rate will be limited by the interest rate cap structure of your loan, which provides protection from large interest rate swings. There are two types of caps: annual, and life-of-the-loan. The annual cap restricts the amount your interest rate can change, up or down, in any given year, while the life-of-the-loan cap limits the maximum (and minimum) interest rate you can pay for as long as you have the mortgage.

ARM: Right for Me?

If an ARM is the right type of loan for you depends on your financial situation and the terms of the ARM. ARMs carry risks in periods of rising interest rates, but they can be cheaper over a longer term if interest rates decline. An ARM may be a good option to consider if you plan to own your home for only a few years, you expect an increase in future earnings, or the prevailing interest rate for a fixed-rate mortgage is too high.

Some questions to consider are:

  • Is my income likely to rise enough to cover higher mortgage payments if interest rates go up?
  • Will I be taking on other sizable debts, such as a loan for a car or school tuition, in the near future?
  • How long do I plan to own this home? (If you plan to sell soon, rising interest rates may not pose the problem they do if you plan to own the house for a long time.)
  • Can my payments increase even if interest rates generally do not increase?
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