Adjustable-rate mortgages, known as ARMs, differ from fixed-rate mortgages in that the
interest rate moves up or down. ARMs are tied to a number of indexes, which usually are
published interest rates. The margin is the amount a lender adds to the index, usually two
percentage points or four percentage points, to set the actual interest rate of the ARM.
The most common index for ARM adjustments is the one-year U.S. Treasury bill. The one-year
bill has a yield very near that offered by the 30-year Treasury bond, which is used to set
rates on 30-year fixed mortgages.
The initial ARM rate is generally lower than the fixed mortgage rate, though in the
current economy the one-year ARM rate has been only slightly lower, about one-quarter to
one-third of a percentage point. Check out the latest bankrate.com survey of ARM interest rates.
Is an ARM For You?
If you plan to be in the house for less than five years, it may be worth paying the lower
interest rate on an ARM vs. a fixed-rate mortgage.
It may be worth investing the difference between an ARM payment and a fixed loan payment in
mutual funds and other investment securities.
If mortgage interest rates are high, you can get a lower rate to start with and hedge your
bet that rates will fall in the future.
Some Facts About ARMs
There are varieties:
- Some ARMs adjust the interest rate every year, while others have
an initial fixed rate period of 3, 5, 7 or even 10 years, after which the rate adjusts on an
annual basis.
- The more short term the index that your ARM is tied to, the more volatile your payments
will be. That's good if interest rates fall, but it can cause trouble if interest rates
rise.
Most ARMS offer built-in caps to protect against enormous increases in
payments:
- Lifetime cap – Limits how much the interest rate can rise
during the life of the loan.
- Periodic rate cap – Limits how much your payments can rise at one time.
- Payment cap – Offered in some ARMs, it limits the amount the payment can
rise over the life of the loan. So if the underlying index rises, your payment would
increase only to the limit of the payment cap.
Keep in mind that rate caps work when the rates rise and when they fall. To get a
better understanding of how ARMS work, we compare adjustable and fixed-rate mortgages in the
next section.
A Final Tip
To keep your financial options open, make sure to ask the mortgage lender if the ARM is
convertible to a fixed-rate mortgage. Also, ask if the ARM is assumable, which means when
you sell your home the buyer may qualify to assume your existing mortgage. That could be
desirable if mortgage interest rates are high.