ADJUSTABLE RATE MORTGAGE (ARM)

An adjustable rate mortgage differs from a fixed rate mortgage in many ways. With a fixed rate mortgage, the interest rate stays the same during the life of the loan. With an adjustable rate mortgage, the interest rate changes periodically, by adding a margin to the borrower's index, and payments may go up or down depending on the published index. The initial rate and payment amount on an adjustable rate mortgage will be fixed for a limited period of time, ranging from just 1 month up to 10 years.

Lenders generally charge lower initial interest rates for adjustable rate mortgages than for fixed rate mortgages. This makes the adjustable rate mortgage cheaper than a fixed rate mortgage for the same loan amount at the beginning. There is also a chance your adjustable rate mortgage could be less expensive over a long period than a fixed rate mortgage if interest rates remain steady or move lower.

Although you may begin with a low monthly payment, you have to realize there is a risk that an increase in interest rates would lead to higher monthly payments in the future. It's a trade-off; you get a lower initial rate with an adjustable rate mortgage in exchange for assuming more risk over the long run.

Shopping for a mortgage is not as simple as it used to be. To compare two adjustable rate mortgages with each other or to compare an adjustable rate mortgage with a fixed-rate mortgage, you need to know about indexes, margins, discounts, caps on rates and payments, negative amortization, payment options, and recasting (recalculating) your loan.

• Adjustment periods.
  All ARMs have adjustment periods that determine when and how often the interest rate can change. There is an initial fixed-rate period during which the interest rate doesn't change - this period can range from as little as 1 month to as long as 10 years. After the initial period, the interest rate will often adjust each year. For example, with a 3/1 ARM, your interest remains the same during the first 3 years, and then can adjust every year following, up to a maximum amount (the "lifetime cap").

• Indexes and margins.
  At the end of the initial period and at every adjustment period, the interest can change based on two factors: the "index" and the margin. Interest rate adjustments are based on a published index. There are many indexes but some commonly used for ARMs are the LIBOR and the U.S. Treasury Bill. The rates for indexes reflect current financial market conditions, which is why your interest rates can change at each adjustment period. The margin is the amount (shown as a percentage) that is added to the index to determine what your new mortgage rate will be until the next adjustment period.

• Caps, ceilings, and floors.
  All ARMs have rate caps, also known as ceilings and floors. Caps decide how much the interest rate can increase or decrease at each adjustment period and over the life of the loan. Most ARMs have a lifetime cap that limits the amount your interest rate can increase over the life of your mortgage.

• The number system.
  There are several types of ARMs, such as the 10/1, 7/1, 5/1 and 3/1. The first number (10 for example) is the length of the initial period, during which the interest rate can't change. The second number (1 for example) is how often the ARM is adjusted after the initial period. So, a 10/1 ARM won't change for the first 10 years, but can change in the 11th year and again every year after that. Depending on the initial cap the change could be as high as 5 percentage points above what it was before.

You need to consider the maximum amount your monthly payment could increase. Most important, you need to know what might happen to your monthly mortgage payment in relation to your future ability to afford higher payments. This is where your mortgage broker comes in handy. They can help you evaluate your current and future financial situation to determine if an adjustable rate mortgage is right for you.