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How Do Adjustable Rate Mortgages (ARMs) Work?

In past decades, many people have been trained to think that a 30-year fixed-rate mortgage is the only way to go when it comes to getting a mortgage. They look negatively on adjustable rate mortgages (ARMs) because they fear the adjustable part. But there are advantages to having an ARM and times where a long-term fixed-rate mortgage doesn't really make as much sense.


Lower Rates and Payments

An ARM, or adjustable rate mortgage, is similar to a 30-year fixed-rate mortgage in that it is also amortized over a 30-year period. But it's usually for shorter-term situations and generally carries a lower interest rate than fixed-rate mortgages. So if you're trying to keep your interest rate and payment low, an adjustable can be a sensible choice. And since it's a short-term mortgage, it's useful to have a lower rate and payment if you know you're only going to be in your home for less than 10 years--especially when most American families generally move within nine years or less.


Some adjustable rate mortgages give you even more financial flexibility if they are available with interest-only payments. During the interest-only period, you decide if you want to pay interest plus principal or just interest alone. The rest of your money can go elsewhere, say, toward other bills or just extra spending money.


A Closer Look at ARMs

Many people tend to shy away from ARMs for the fact that the rate is adjustable. However, there are a few caveats to this:

  1. While ARMs do have an adjustable rate, the rate is fixed for six months, one, three, five, seven, and sometimes even nine years, depending on which term you choose. The rate doesn't begin to adjust until after the fixed-rate period.
  2. Although the rate can adjust up, don't forget that it can also adjust down as well.
  3. Most people who have an adjustable rate mortgage usually refinance it when it's time for the rate to adjust. That way, they have some control over their interest rate.

Caps and ARMs

If you have an adjustable rate mortgage and can't or don't want to refinance when it's time for the rate to adjust, it's important to understand what happens to the rate after the fixed-rate period.


When the rate on an ARM adjusts, there are limitations on how much it can increase or decrease. These limitations, called "caps" include the "initial cap", the "periodic cap", and the "lifetime cap". The initial cap is the limit on how much the rate can adjust the first time it adjusts. The periodic cap is the limit on how much the rate can adjust after the first adjustment. The lifetime cap is the limit on how much the rate can adjust over the life of the loan. Different ARMs carry different caps, depending on the program.


Let's say your ARM has caps of 5/2/5. The first five is the initial cap; the second number is the periodic cap; and the third number is the lifetime cap. If your rate is 6.5 percent, then the initial cap says the first adjustment is your rate plus or minus five percent--so it can go as high 11.5 percent or as low as 1.5 percent (though it's pretty unlikely that rates would change that significantly). The periodic cap says the second and subsequent adjustments are your rate (6.5 percent) plus or minus two percent--so no higher than 8.5 percent and no lower than 4.5 percent. The lifetime cap says the rate can never go higher or lower than your rate (6.5 percent) plus or minus five percent.


There are times when you'd want to refinance and times when you don't. So why would you not refinance your ARM when it's going to adjust? Well, as we said, rates can go down as well as up. There are some people who are not afraid of risk and are willing to gamble that their rate could go down. To be somewhat savvy, it's wise to follow what's happening in the market to know whether short-term rates will go up or down. The Federal Reserve is usually the entity that affects short-term adjustable rates. They meet eight times a year and decide whether to increase, decrease or maintain short-term rates as a control measure over inflation.


Deciding whether you should get an ARM and/or whether to refinance it is really your own decision. But if you can answer a few questions--whether or not you want a lower rate and payment; whether or not you're only going to be in your home for less than 10 years, and whether you can stand a little risk in terms of the interest rate--then, you'll be closer to making the right decision. Either way, you should confer with an experienced mortgage expert to be sure you're making the right decision.

By Diane Tuman

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  • Last edited October 12 2012
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