A much smaller number of owners have adjustable-rate mortgages, or ARMs. As the name suggests, interest rates on ARMs vary over the term of the loan. The rate adjusts periodically based on a pre-selected index and margin and typically reset monthly or annually. If rates decline over the life of a loan, an ARM makes it possible to save money compared to the cost of a fixed-rate loan.
ARMs come in a wide variety of formats to appeal to all sorts of borrowers and typically come with a lower initial interest rate than a fixed-rate mortgage. The most common type of ARM is a hybrid ARM that features a fixed interest rate for an initial period (typically 3, 5, 7 or 10 years), and then becomes adjustable thereafter.
Is an ARM right for you?
If you don’t like to take risks and want to be able to budget your mortgage payment, then a fixed-rate mortgage is best for you. If rates are low and you think they will rise, a fixed-rate loan makes even more sense. In the future, if rates drop below your loan's rate, you can refinance to take advantage of the decline.
However, if interest rates remain steady or decline, an ARM could be less expensive over a long period than a fixed-rate mortgage. If you are willing to incur a little risk in return for potential savings on interest, then you should investigate an ARM.
If you are definitely planning to sell your house in 5 to 7 years, you might want to look into a hybrid ARM that resets after the time you plan to sell.
Keep in mind that if rates rise so you want to refinance out of your ARM loan, as with most refinances you will need 20 percent or more equity in your home. If home prices have not appreciated since you took out your ARM or you have not paid down enough of your principal balance, you will likely have to put cash into the deal to make it work.
Know the details before you go the ARM route
ARMs were responsible for many of the foreclosures in recent years. Believing that homes would continue to appreciate rapidly, many buyers took out ARMs thinking that they could refinance or sell if they needed to. When home values fell, they were unable to do so.
Before you take out an ARM, do your homework. Understand where the risks are and be confident that you will be able to weather them.
Important questions to ask your mortgage lender
First-time home buyer? get your credit in order
How mortgage rates are established in the U.S.
How each borrower's interest rate is determined