Adjustable Rate Mortgages (ARMs)

Adjustable-rate loans get their name because the rate you pay changes according to a set formula as interest rates fluctuate on the open market. As noted above, the upside is that lenders charge a lower rate for such loans because you are taking on some of the interest rate risk. This makes your monthly payments lower — at least in the beginning. Such loans provide a way for many buyers to afford a larger loan amount for a given monthly payment. An adjustable works out wonderfully if rates drop — something you should never count on. But watch out if interest rates rise. In a year or two, your payments could exceed what you would have paid for a 30-year fixed.

The trick with adjustables is to tailor the loan to your needs. Generally, the cheapest rate out there is on a one-year adjustable. (Well, yes, there are even cheaper loans that adjust monthly, but those are too risky for most buyers.) With a one-year, your rate can change annually, making these loans particularly risky. Lenders often try to draw you in with “teaser” rates that are especially cheap for the first year, but which will almost certainly jump up the next year.

There is a limit to how much an adjustable can adjust, however. Lenders limit the amount the rate can rise, often to no more than two points a year, with a lifetime cap of six points. Moreover, if you are willing to endure the expense of refinancing after a year, it’s possible you’ll come out ahead.

Another option is what’s known as a “delayed adjustable.” When you see “3-1 adjustable” or “5-1 adjustable” it means that the loan stays fixed for three or five years and then resets annually. The same pattern holds for a 7-1 or a 10-1. The longer the fixed period, the higher the rate. The idea is to match the loan to the amount of time you plan to stay in the house. For instance, if you expect to move after three years, a 3-1 is a great option. After 10 years, you might as well opt for a fixed rate. The price difference will be minimal.

ARM Features

Adjustable rate mortgages all have certain similar features. They have an adjustment period, an index, a margin, and a rate cap. The adjustment period is simply how often the rate changes. Some change monthly, some change every six months, some only adjust once a year and some adjust only after an initial fixed term of a few years. Indexes are a simply and easily monitored interest rate that moves up and down over time. Adjustable rate mortgages have different indexes. The margin is the difference between your interest rate and the index. The margin does not change during the term of the loan.

So if you have an adjustable rate mortgage and you wanted to calculate your interest rate on your own, all you have to do is look up the index in the paper or on the internet, add the margin, and you have your rate.