An Adjustable Rate Mortgage (shortened to ARM) is a mortgage where the interest rate on the mortgage varies. In an ARM, there is an initial period of a fixed rate, then the interest rate changes. When compared to a fixed rate mortgage, an adjustable rate mortgage differs because the interest rate will change over time to match the market. Specifically, banks will link the interest rate on an ARM with certain indexes.
Each ARM is defined by a few major criteria. First of all, the initial interest rate and the initial interest period. The initial interest rate on an ARM will be defined by the bank. As a general rule, this interest rate will be lower than a fixed rate mortgage, in order to make the ARM more attractive to customers. The initial interest period is the length of time that this fixed interest rate will be applied. In a 5-1 ARM, the 5 indicates that the initial interest period is five years long.
The next major part of an ARM is how the interest rate will change. In an 5-1 ARM, the rate will change every 1 year. If a mortgage were a “5-2” ARM, the interest rate would change every 2 years. The change of the interest rate will depend on what the ARM is linked to. If the index that the ARM is linked to has increased, then the rate of interest on the mortgage will increase, and the mortgage will become more expensive overall.
Because the economy generally improves over time, an ARM usually will cost more, not less, than its original fixed rate. A fixed rate mortgage is generally a better option for home-buyers. At this time, fixed rate mortgages are at incredibly low interest rates due to the financial downturn. There is not really any reason one would go with an ARM instead of a fixed rate right now.
In addition to the increase in cost over time, ARM’s have also had a bad reputation with errors. Banks admit that “up to 50% of ARM’s” are miscalculated, causing homeowners to pay more than they should.