Adjustable-rate mortgages (ARMs) are different from fixed-rate mortgages because they adjust depending on the current rates and can cause your monthly payment to go up or down. They can be a great option when rates are high, or if you don't plan on being in the home for the full length of the loan. In this article we will try to cover some of the basics as well as the pros & cons of adjustable-rate mortgages.

Adjustable-Rate Mortgage Basics

Because lenders are asking you to assume the risk of fluctuating interest rates, you can often receive initial rates that are lower than fixed-rate mortgages for the first couple years.  You will often see ARMs listed as 3/1, 5/1, 7/1, or 10/1 which are considered "Hybrids."  Using 3/1 as an example, it would mean that you would get a fixed rate for 3 years, and then you will receive your first adjustment.  After that it will be adjusted yearly on the date the loan was originated.

How ARM Rates Work

When the fixed-rate period is over, often referred to as the honeymoon period, you will then be subject to the changing rates.  Those rates come from an index which is agreed upon in the closing documents.  The indexes are:

• 11th District Cost of Funds Index (COFI)
• Weekly Constant Maturity Yield On One-Year Treasury bill
• London Interbank Offered Rate (LIBOR)

The bank uses that rate as the base, then adds a margin to that to figure out your new rate. That rate will be changed each adjustment date which is usually anywhere from a month to a year apart.

ARM Safety Net

It's important to realize that even though your payments can go up dramatically, there are limits. ARM's come with "Caps" that limit the amount that your rates can go up during the loan.

The most common types of caps are: The Payment Cap which limits the amount your payment can raise. The Lifetime Cap which limits the amount the interest rate can go up during the life of the loan. Also the Periodic Rate that can limit how much the rate can increase during a specific period. Generally Periodic Caps are done annually which doesn't provide too much protection depending how long you plan to be paying on the loan.