Adjustable rate mortgages are a popular choice for buyers who want the lowest possible mortgage rate and are comfortable with the risk of higher payments down the road.

The most common type of mortgage is a fixed-rate loan, which has an interest rate that remains the same or fixed for the life of the loan. An adjustable rate mortgage or ARM has an interest rate that adjusts at pre-set intervals, such as every 5 years or every year. ARMs usually have the lowest mortgage rates to start, although the rate will change following an initial fixed period that is usually around 5 years.

Adjustable rate mortgages are much more complex than fixed rate loans and there are many types. Common types of ARMS include:

• 1-year ARM - fixed rate for the first year then annual interest rate adjustments.
• 5/1 ARM - hybrid loan with a fixed interest rate for 5 years then annual adjustments.
• 7/1 ARM - fixed rate for the first 7 years then annual adjustments.

All adjustable rate mortgages are tied to an index which determines how interest rates change after the initial fixed period. There will also be caps, which determine how much your rate can possibly increase once the adjustments begin. Adjustment caps limit how much the rate can increase from one adjustment to the next while the lifetime cap limits how much your rate can increase over the entire term of the mortgage.

Important Considerations

If you are considering an adjustable rate mortgage, there are a few questions you should ask yourself:

• Do you plan to move? An ARM can be an excellent way to save interest on your mortgage if you plan to sell your home and move during the early years of the loan, especially before the interest rate resets.
• Do you expect your income to increase? You can expect the mortgage payment on an ARM to go up once the interest rate resets. If you expect your income to increase in the years to come, an ARM can still be affordable.
• What is the current ARM to fixed rate spread? The difference in interest rates between adjustable rate loans and fixed loans is called the spread. The greater the spread, the more an ARM can make sense.
• Are you getting a jumbo loan? Jumbo loans are mortgages exceeding conforming loan limits, or $424,100 in most areas. Fixed rate loans for jumbo mortgages tend to be high, whereas the interest rate for jumbo ARMs can be very competitive. If you are getting a jumbo mortgage, an ARM may save you a substantial amount of money.

Pros and Cons

An adjustable rate mortgage is riskier than a fixed rate mortgage, but there are benefits:

• An ARM can save you a substantial amount of money in interest during the initial fixed period
• An ARM can be the ideal choice for borrowers who aren't going to stay in the home more than 5-7 years because the interest rate won't even have time to reset before the home is sold
• When interest rates are dropping, an ARM can help you get lower mortgage payments down the road that are more in line with current rates.

Don't forget to consider drawbacks to an ARM:

• Interest rates are only going up. With an ARM, you can expect your monthly mortgage payments to increase, sometimes dramatically.
• Some ARMs have a prepayment penalty or a fee that is charged if you refinance the loan or sell the home within the first 5 years or so.
• ARMs have complicated terminology and conditions

Who Offers Adjustable Rate Loans?

Major lenders as well as smaller institutions and credit unions all offer adjustable rate mortgages. In addition to working directly with a loan officer at a bank or credit union, you can also choose to work with a mortgage broker to find an adjustable rate loan. Mortgage brokers help you find the best mortgage for your needs with the lowest interest rate by comparing loans at numerous institutions.

When to Use an Adjustable Rate Mortgage

An adjustable rate mortgage is recommended in several circumstances. If you plan to sell your home within the next 5-8 years, an ARM can make sense by giving you a much lower interest rate than a fixed mortgage. By the time you're ready to move, your loan will be resetting to a higher rate and you will have enjoyed years of reduced interest charges.

An ARM can also be a good option if you expect your income to increase to cover the shock of increasing mortgage payments. You always have the option of refinancing an ARM into a fixed mortgage later, although this will mean additional closing costs and other fees that can eat into your savings.