An adjustable rate mortgage is a type of mortgage where the interest rate varies over the life of the loan rather than stay fixed. Adjustable rate mortgages are commonly referred to as ARMs. Adjustable rate mortgages have a fixed rate for a period of time, then the rate “floats”. This means that based on market variables at the time the rate will change.
After the fixed rate period for an adjustable mortgage is over, the rate will then become variable. The interest rate changes periodically depending on the terms set for your ARM. The initial rate typically starts lower than that of fixed-rate mortgages. Once a year is the most common, but shorter and longer periods are also available. Some ARMs exist that change their rate on an unfixed pattern also exist.
Adjustable rate mortgages can be complex, because the interest rate is based on many market factors. The interest rate for ARMs are tied to specific indexes, which impact the rate of your mortgage. An index is basically the reference for your interest rate. Typical indexes are the rate on U.S. Treasury Bills, the prime rate, the London Inter-Bank Offering Rate, or the Federal Funds Rate, but there are many others. The actual rate of your ARM will be the rate of the index your ARM plus the margin of your ARM. Indexes are the variable, while margins are pre-determined and stay constant. If the market indicators for your index go up, your interest rate will rise. If the market indicators go down, your rate will fall, however not all ARMs adjust downward.
Adjustable rate mortgages come with many benefits, despite having some level of uncertainty to them. A major advantage that adjustable rate mortgages present is that they allow people to reap the benefit of falling interest rates without having to refinance. Another advantage is that ARMs typically start out with lower interest rates than fixed mortgages do. This can be very beneficial to those who are investors or want to pay off their mortgage in a shorter time than their terms allot. Less money spent towards interest every month means more money in your pocket to spend on higher-yielding investments. Since lenders know your monthly payment will be lower at the beginning of your term, borrowers can get more expensive homes than would with a fixed rate mortgage.
Some main things to consider while getting an adjustable rate mortgage are: the initial rate and payment that will you will have to make. The adjustment period of your loan, which is the period in between rate changes. The index of your loan, which is the benchmark for how well markets are doing generally. The margin of your loan, the percentage mark up the lender puts on your adjustable rate mortgage which stays constant throughout the life of the loan, and the interest rate caps. There are periodic interest rate caps, which limit the amount your interest rate can go up or down from one period to the next, and lifetime interest rate caps, which limit how much the interest rate can increase over the life of the loan.