Also known as a variable rate mortgage or floating rate mortgage, an adjustable rate mortgage carries an interest rate that a lender can vary during the loan term. This type of mortgage loan is designed to shift the risk of rising interest rates from the lender to the borrower. However, in order to offset the increased interest rate risk, ARMs typically offer borrowers a lower rate-compared to a fixed rate mortgage-during the first year, generally starting with an interest rate that is 2-3% below a comparable fixed rate mortgage.

However, the interest rate will vary depending on changing market conditions; if interest rates go down, your mortgage payment will drop also. Conversely, if rates go up, your monthly mortgage payment will go up, too.

There are also ARMs that combine aspects of fixed and variable rate mortgages starting at a low fixed rate for a number of years, then adjusting to market conditions. These loans are often quoted as a figure such as 5/1 or 10/1, where the first number represents the initial fixed rate period and the second number represents the frequency at which the rate will adjust after the fixed rate period. The majority of lenders offer initial fixed rate periods for 1, 3, 5, 7 and 10 years after which the rate will adjust every 1 year thereafter.

For example: a 5/1 ARM with a rate of 7.00% indicates a fixed rate for 5 years at 7.00% which will adjust every 1 year thereafter.

Terms

If you are considering an adjustable rate mortgage, there are a number of terms that you should be familiar with.

Index

An index is a benchmark used by a lender to adjust an ARM's interest rate. Mortgage interest rates are tied to current market conditions, and a good measure of market conditions are yields on US Treasury securities. Other commonly used indexes include the average cost of federally-insured savings and loan funds.

When the US Treasury securities index is used, it is normally taken from the weekly average yield on a 1, 3 or 5 Year Treasury Security 30 or 45 days prior to your adjustment date. It's worth bearing in mind that a 1 Year Treasury yield is lower than a 5 Year Treasury yield.

Margin

Also known as the 'spread'. This is the percentage amount a lender can add to the value of the index specified in the loan agreement. A lender could add a margin of greater than 3% to the index to determine your new rate. When shopping for an ARM you want to look for the lowest term treasury security index with the lowest margin.

Initial Rate

The initial rate is the interest rate at the start of the mortgage, and is typically lower than the amount you would owe on a fixed rate mortgage. Very low initial rates are sometimes offered to persuade you to enter into the loan.

Adjusted Effective Rate

This is the rate you pay when the adjustments start. It is calculated as the value of the index specified in the loan agreement plus the margin. For example, if the index value rises to 7.5% and the margin is 3%, the adjusted effective rate is 10.5%.

Adjustment Period

This is when mortgage payments or interest rates may change. This may be every 6 months, annually, or every 3 years.

Caps

ARMs may include several kinds of caps.

• An interest adjustment (or per adjustment) cap limits the amount by which the interest rate can rise or fall at each adjustment period. For example: a 3% interest cap means the maximum your rate could go up or down in any adjustment year is 3% over the current rate. If the current rate is 7.00%, then the maximum rate you could pay in the next adjustment year is 10%.
• A payment cap limits the increase in monthly payments at each adjustment period.
• A lifetime interest cap limits the maximum interest the lender can charge during the loan term.
• A lifetime payment cap limits the percentage by which principal and interest payments can increase over the full term of the loan. A 7% lifetime cap means that the maximum interest rate you could ever pay in any year is 7% over the start rate or 14%.

Putting it all Together

The initial fixed rate period is perhaps the most important factor when determining whether or not an ARM is for you and second most important is the margin and index. For example; say you have been quoted the following rates and terms on a 3/1 ARM both with a 1 Year Treasury Security index:

• Loan #1 - Rate 6.125%: Caps are 2% per adjustment, 5% lifetime with a Margin of 2.50%
• Loan #2 - Rate 6.00%: Caps are 2% per adjustment, 6% lifetime with a Margin of 2.75%

On the surface, loan #2 looks like the better loan since the interest rate is lower than loan #1. This reasoning holds true if you plan on moving at the end of the three years. However, if there is a chance you will keep the loan beyond the 3 year term, then the first loan will probably be better as the lifetime cap is a full 1% lower than loan #2. In addition, when loan #1 adjusts, the rate will always be .25% below loan #2 (unless it adjusts the full 2%).

Adjustable rate mortgages are not for everyone. If the possibility of paying a future higher interest rate is not for you, you may be better off with a fixed rate mortgage.