With a fixed-rate mortgage, the interest rate stays the same during the life of the loan. With an adjustable rate mortgage (ARM), the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly.
ARMs
| Pro |
Con |
| Lower initial interest rates. |
You assume risk of future rate increases. |
| If interest rates remain steady or decrease, could be less expensive over time. |
If interest rates increase, you'll be faced with higher monthly payments in the future. |
Before you decide that an ARM is right for you, ask yourself the following questions:
- Is my income likely to rise enough to cover higher mortgage payments if interest rates go up?
- Will I be taking on other sizable debts, such as a loan for a car or school tuition, in the near future?
- How long do I plan to own this home? (If you plan to sell soon, rising mortgage rates may not pose the problem they do if you plan to own the house for a long time.)
- Can my payments increase even if interest rates generally do not increase?
Basic ARM features
The adjustment period: with most ARMs, the adjustment period occurs every one, three or five years, resulting in a change in your interest rate and monthly payment.
The index: most lenders tie ARM interest rate changes to changes in an index rate. These indexes go up and down in accordance with interest rates.
The margin: to determine the interest rate on an ARM, lenders add to the index rate a few percentage points called the margin. The amount of the margin can differ from one lender to another, but it is usually constant over the life of the loan.
Adapted from the "Consumer Handbook on Adjustable Rate Mortgages" published by the Federal Reserve Board and the Office of Thrift Supervision.
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