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What Is an Adjustable Rate Mortgage?

What you'll learn: The pros and cons of adjustable rate mortgages

EXPECTED READ TIME: 2 MINUTES

What Is an ARM?

An adjustable rate mortgage, or ARM, is a mortgage in which the interest rate can change over time. With an ARM, your mortgage payment either goes down or up, depending on the current index rate your mortgage is tied to. While having your rate be unknown over time can cause some anxiety, there are great reasons why you may want to consider an ARM when you purchase your home.

How Does an ARM Work?

An ARM rate is determined by an index rate and a margin rate. An index rate is generally driven by market forces and can therefore go up or down over time. There are several different indexes on which ARMs are based on. Your loan officer and your paperwork can explain which index your loan is tied to. A margin rate is fixed over the life of the loan and combined, the two are what your mortgage payment is based on.

As an example, if the index rate is currently 1.5%, and your margin is 3%, your total interest rate would currently be 4.5%. Because the index rate can change over time, your interest can fluctuate up or down.

Some caps can protect you against dramatic increases in index rates. For example, some caps assign a limit to how high your rate can climb over the life of the loan. That way you know it will never be more than that cap amount. Other types of caps may include a maximum increase year over year or a maximum dollar amount per month versus index rate. Talk to your loan officer to learn more about caps on ARMs.

What Are the Different Types of ARMs?

ARMs can come in different forms depending on the lender. As an example, a 5/1 ARM is represented by a five-year introductory rate where the rate is constant and does not change. After that period, the ARM can fluctuate based on the index rate every year after. Other types of ARMs offered by different lenders might be a 3/1 ARM — which locks in a constant rate for three years — or a 7/1 ARM — which locks in a constant rate for seven years. Each can come with slightly different interest rates. Be certain to understand all the parameters to determine if an ARM is right for you.

What Are the Benefits of an ARM?

In general, ARMs offer lower introductory rates compared to conventional mortgage interest rates. That can mean the difference between getting that house you want versus looking elsewhere. Another benefit of a lower interest rate is that you might pay more towards the principal every month and pay off the loan faster. A big potential benefit is that if interest rates go lower over time, so does your payment.

What Are the Cons of an ARM?

The most obvious risk of an ARM is that you lose the security of a consistent rate and mortgage payment over time. Should rates increase year after year, your mortgage payment will also increase. This means your mortgage payment may fluctuate from year to year making it harder to budget and possibly afford other items.

Is an Adjustable Rate Mortgage Right for Me?

Everyone's financial situation is different. With ARMs, it is your financial situation combined with the state of the economy and other factors like how long you plan on being in your home. For example, during a downturn in the economy, rates may go down, which offers you lower interest rates over time. If you're a typical homeowner, you may only be in your home for seven years before you move. In that case, a 7/1 ARM is much like a fixed rate because you are locked into that introductory rate for the first seven years.

In the end, it's always great to plan, do your homework, and understand all of your loan options and talk to your loan officer.

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