How does an adjustable rate mortgage work?

The rate is fixed for a designated period (eg. for 5 years for a 5/1 ARM ) and then the rate/payment will adjust annually based on a predetermined Index (eg. 1 year libor) and a margin (fixed). There are "caps" in place to control how much the rate can change.

An Adjustable Rate Mortgage, or an ARM, is a mortgage whose interest rate varies throughout the life of the loan.

When an ARM is taken out, it initially goes through a fixed interest period. The period can last from one month all the way to ten years depending on how you choose. The rate does not adjust until after this period is up. After the fixed rate period ends, the interest rate will begin to change based on changes on an interest rate index. The amount of time before your rate changes after the fixed interest period varies based on what you choose when the mortgage is being taken out. ARM rates are higher on loans that have a longer life. For example, the rate of a 10 year ARM is going to be higher than the rate of a 5 year ARM. Many ARMs also have a rate adjustment cap. This cap is the most that rate can move from one adjustment period to the next. As an example, imagine you took out a 5/1 ARM. The "5/1" part means that the initial rate period lasts 5 years and adjusts every year after that. The starting rate is 4%, the index is valued at 4.5%, and the margin is 3%. If a cap was not included, the rate would go from 4% to 7.5% and would remain there until the next adjustment period. If there was a cap of 2%, the rate would only climb to 6% for the next year. If every variable stayed the same at the end of the first adjustment period, the rate would then move from 6% to 7.5%.

An ARM has many benefits over a Fixed Rate Mortgage, or an FRM. An ARM can allow for much more flexibility when it comes to finances. Some ARMs have the option for interest only payments, which means that you have the choice to pay just the interest that would have been required, or you can pay the interest and any amount of principal that you can afford at the moment. This option allows for the principal money to be allocated to other bills if you find it necessary. Another benefit is that if the loan gets taken out at a time when interest rates are falling, a significant amount of money can be saved compared to an FRM. For example, let's say that interest rates on FRMs average out to be around 4% and an ARM with a 5 year fixed rate period averages out to around 3.125%. If a $200,000 loan was taken out, the payment would be around $100 less monthly on the ARM than the FRM.

ARMs do have risks though. When taking out an ARM, one should always consider the worst possible outcome. The worst possible outcome is the constant rising of the rate until the monthly payment exceeds what the person paying can afford. The easiest way to avoid this outcome is to ensure that the entirety of the loan can be paid before the adjustment period.

In general, there are two major types of home loans: adjustable Rate Mortgages (ARMs) and fixed rate mortgages. With an adjustable mortgage, the interest rate you are charged can change over time. Usually a lender will select an index rate, then add their margin to come up with the actual rate you will be charged. Most index rates mirror the economy, so you can expect your rate to fall as the economy struggles, or to rise during times of growth.

Most ARMs also have a fixed introductory period where the interest rate will remain stable. During this period, which can last for as little as a month or as long as a few years, depending on the type of loan, ARMs tend to be cheaper than comparable loans available at fixed rates. ARMs are therefore a good option for borrowers who intend to stay in their homes for less time than the introductory period on an available ARM. However, borrowers who end up staying for longer than they intended might end up having to pay to refinance into a more stable loan type.

In addition, ARMs are often used by borrowers who cannot get a fixed mortgage at a good rate.  For many borrowers, the first few years of a fixed rate mortgage can be tough, as there is very little room between their income and their mortgage. ARMs allow these buyers to purchase their homes at temporarily cheaper rates in order to save money or purchase a larger home. However, this is a risky plan; if interest rates rose in the future the borrower could get caught in a loan they simply couldn’t afford.

You should always keep the worst case scenario in mind when looking at an ARM. For example, consider a 30-year, $200k loan at 5% interest with a 6% lifetime cap. By adding the lifetime cap to our interest rate, we see that our interest rate can max out at 11%. At 5%, our monthly payments would be $1073.64. If the worst happened and interest rates rose dramatically pushing our rate to 11%, our new monthly payment would be $1,885.65. It’s important to note that these are unlikely circumstances, but since they could potentially happen, being able to handle them is vital.

For most borrowers, an adjustable rate mortgage should be an option, as long as they understand how to properly use one. Don’t be lured in by the promise of lower monthly payments, and make sure the ARM will be a better bet for you over the course of the loan than a fixed rate mortgage. That entails making sure you are capable of handling the loan in the worst case scenario; if not, an ARM could lead you into foreclosure.