How Do ARMs Work?

Adjustable Rate Mortgages have a fixed rate for a specified period of time, usually between 1 and 10 years. After the fixed period, the rate can adjust. For example, if you see a mortgage that's a 5/1 ARM, the first number, 5, is the number of years the initial rate stays fixed. The second number, 1, is how often the rate can adjust after the 5th year, in this case, annually. (So a 3/3 has a fixed rate for 3 years then adjusts every 3 years after that.) Just like with a fixed-rate mortgage, you can still plan to pay the mortgage off over a long time, up to 30 years, but the rate is initially fixed at a lower rate for a shorter period and then it adjusts annually after that.

With most ARMs, the interest rate and monthly payment change every year, every three years, or every five years. However, some ARMs have more frequent rate and payment changes. The period between one rate change and the next is called the adjustment period. A loan with an adjustment period of one year is called a one-year ARM, and the interest rate can change once every year. Most lenders tie ARM interest-rate changes to changes in an index rate. These indexes usually go up and down with the general movement of interest rates. If the index rate moves up, so does your mortgage rate in most circumstances, and you will probably have to make higher monthly payments.

On the other hand, if the index rate goes down, your monthly payment may go down. Lenders base ARM rates on a variety of indexes. Among the most common indexes are the rates on one-, three-, or five-year Treasury securities. Another common index is the national or regional average cost of funds to savings and loan associations. A few lenders use their own cost of funds as an index, which gives them more control than using other indexes. You should ask what index will be used and how often it changes. Also ask how it has fluctuated in the past and where it is published.

To determine the interest rate on an ARM, lenders add to the index rate a few percentage points, called the margin. The amount of the margin may differ from one lender to another, but it is usually constant over the life of the loan. Index rate + margin = ARM interest rate This type of loan program requires you to carry on with varying monthly payments at certain intervals of time. Since there can be significant changes in the payment, such loan programs are considered to be risky compared to fixed rate mortgages on which you can maintain stable monthly payments. In spite of this drawback, you can benefit from this loan product depending upon your financial needs and circumstances.