An adjustable rate mortgage (ARM mortgage) is a mortgage whose interest rate is linked to an economic index. The interest rates and your payments will be adjusted periodically as the index fluctuates. The index is a rule used by lenders to measure the changes in interest rates. A common index used by lenders measures the activity of one, three and five year Treasury securities.
When applying for an ARM mortgage, you also need to consider the lender's margin. This is in effect the lender’s markup; it is the lender’s cost of doing business and the profit they intend to make on the loan. There is also the adjustment period to consider. This is the period between interest rate adjustments. An ARM mortgage with annual adjustments means that interest rates can change annually.
Interest rates for an ARM mortgage are lower than those of a fixed mortgage. Fixed rate mortgages have interest rates that remain the same over the life of the loan. A lower rate of interest means lower repayments; this is beneficial if you wish to apply for a larger loan. If you plan to sell your house quite quickly, then the interest rates may not be such a consideration for you. If you expect your income to increase, it may cover the cost of interest rate fluctuations.
All of these aspects should be taken into consideration if you are thinking of taking out an ARM mortgage. An ARM mortgage can be converted into a fixed rate mortgage in the future, but the cost of doing this may see your savings spent on the conversion fees, which may equal the initial savings you made when taking out your ARM mortgage in the first place.
There are interest rate caps that can be applied to an ARM mortgage. An overall cap will limit how much the interest rate can increase over the life of the loan. Overall caps entered the law in 1987. Periodic caps are a way of limiting the amount your interest can increase from one period of adjustment to the next. You can also have a payment cap that limits the amount your monthly payment can increase at each adjustment.
A word on negative amortization, which occurs when your payments do not cover the cost of the interest. The unpaid amount will be added back to your loan and even more interest will be generated on the debt. If this is allowed to continue, then you could end up making many payments and still owe more than you did at the beginning of your loan. As with all mortgages, get the best advice you can from banks and lenders, and remember to get various quotes before signing.