Adjustable-rate mortgages, or ARMs, differ from fixed-rate mortgages in that the interest rate and monthly payment move up and down as market interest rates fluctuate.
Most have an initial fixed-rate period during which the borrower's rate doesn't change, followed by a much longer period during which the rate changes at preset intervals.
Adjustable rates start low
Rates charged during the initial periods are generally lower than those on comparable fixed-rate mortgages. After all, lenders have to offer something to make it worth their while to assume the risk of higher rates in the future.
The initial fixed-rate period can be as short as a month or as long as 10 years. One-year ARMs, which had their first adjustment after one year, used to be the most popular adjustable, and were the benchmark. Recently the standard has become the 5/1 ARM, which has an initial fixed-rate period that lasts five years; the rate is adjusted annually thereafter. That type of mortgage, which mixes a lengthy fixed period with an even lengthier adjustable period, is known as a hybrid. Other popular hybrid ARMs are the 3/1, the 7/1 and the 10/1.
These hybrid ARMs -- sometimes referred to as 3/1, 5/1, 7/1 or 10/1 loans -- have fixed rates for the first three, five, seven or 10 years, followed by rates that adjust annually thereafter.
After the fixed-rate honeymoon, an ARM's rate fluctuates at the same rate as an index spelled out in closing documents. The lender finds out what the index value is, adds a margin to that figure andrecalculates the borrower's new rate and payment. The process repeats each time an adjustment date rolls around.
Most ARM rates are tied to the performance of one of three major indexes:
1. The weekly constant maturity yield on the one-year Treasury Bill: The yield debt securities issued by the U.S. Treasury are paying, as tracked by the Federal Reserve Board.
2. The 11th District Cost of Funds Index (COFI): The interest financial institutions in the western U.S. are paying on deposits they hold:
3. The London Interbank Offered Rate (LIBOR): The rate most international banks are charging each other on large loans.
Sky's not the limit
Borrowers have some protection from extreme changes because ARMs come with caps. These caps limit the amount by which ARM rates and payments can adjust.
Caps come in a couple of different forms. The most common are:
Periodic rate cap: Limits how much the rate can change at any one time. These are usually annual caps, or caps that prevent the rate from rising more than a certain number of percentage points in any given year.
Lifetime cap: Limits how much the interest rate can rise over the life of the loan.
Payment cap: Offered on some ARMs. It limits the amount the monthly payment can rise over the life of the loan in dollars, rather than how much the rate can change in percentage points.
Around the turn of the 21st century, lenders began to market interest-only mortgages to middle-class borrowers. Formerly the preserve of what lenders called "affluent clients," interest only mortgages are usually adjustables. The borrower is required to pay only the interest for a specified period, often 10 years. After that, it adjusts to the going interest rate, as tracked by a specified index. After that, the loan amortizes at an accelerated rate. During the interest-only period, the borrower can choose to pay some principal, too. By providing flexibility in the size of monthly payments, interest-only mortgages often are a good match for people with fluctuating monthly incomes: salespeople who are paid by commission, for example.
Variety of flavors
Some ARMs come with a conversion feature that allows borrowers to convert their loans to fixed-rate mortgages for a fee. Others allow borrowers to make interest-only payments for a portion of their loan terms to keep their payments low. But no matter the exact terms, most ARMs are more difficult to understand than fixed-rate loans.
To keep your financial options open, make sure to ask the mortgage lender if the ARM is convertible to a fixed-rate mortgage. Also, ask if the ARM is assumable, which means when you sell your home the buyer may qualify to assume your existing mortgage. That could be desirable if mortgage interest rates are high.