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Adjustable-rate mortgages

Adjustable-rate mortgages, or ARMs are different from fixed-rate mortgages in that the interest rate and monthly payments move up or down as market interest rates fluctuate.

Most ARMs have an initial fixed-rate period during which the interest rate doesn’t change, but after that period, the rate changes at preset intervals (usually, a year).

Adjustable-rate mortgages are popular because the initial rates are almost always lower compared to the rates of the fixed-rate mortgages. The initial, fixed-rate period could be as short as one month and as long as 10 years. The industry standard nowadays is the 5/1 ARM, which has an initial fixed-rate period of 5 years; and the rate is adjusted annually afterwards. Other ARMs available on the market include the 3/1, the 7/1 and the 10/1.

After the initial fixed-rate period, the interest rate fluctuates depending on the index agreed on the closing documents. Major indexes used are the weekly constant maturity yield on one-year Treasury bill, COFI and LIBOR. The lender adds a margin to the index figure and recalculates the borrower’s new rate and monthly payment. This process repeats each time an adjustment date rolls around.

Some adjustable-rate mortgages agreements allow borrowers to convert their loans to a fixed-rate mortgage for a certain fee. Other ARMs are ‘assumable’ which means that the borrower could sell his home to another buyer who could assume the first borrower’s mortgage.

While many borrowers fear that the rates after the initial fixed-rate period would go sky-high, most ARMs come with caps limiting the amount by which rates and payments adjust. For example, there are periodic rate caps, that prevent the rate from rising more than certain percentage points in any given year. There are also lifetime caps, that limits how much the interest rate can rise over the life of the loan, and payment caps, that limit the fluctuation of monthly payments.