Adjustable-rate mortgages, or ARMs, have monthly payments that can move up and down as interest rates fluctuate.
Most have an initial fixed-rate period during which the borrower's rate doesn't change, followed by a longer period during which the rate changes at preset intervals.
What is an adjustable-rate mortgage?
An adjustable-rate mortgage, or ARM, is a home loan with an interest rate that can change periodically. This means that the monthly payments can go up or down.
Generally, the initial interest rate is lower than on a comparable fixed-rate mortgage.
After the fixed-rate period ends, the interest rate can go lower, so monthly payments can fall, too.
After the fixed-rate period ends, the interest rate can rise, so monthly payments can go up, too.
Interest rates are unpredictable, so you can't predict what your payments will be in the future.
Adjustable rates start low
Interest rates charged during the initial fixed-rate period are generally lower than those on comparable fixed-rate mortgages.
The most popular adjustable-rate mortgage is the 5/1 ARM:
The 5/1 ARM's introductory rate lasts for five years. (That's the "5" in 5/1.)
After that, the interest rate can change every year. (That's the "1" in 5/1.)
Some lenders offer 3/1 ARMs, 7/1 ARMs and 10/1 ARMs.
ARMs follow rate indexes and margins
After the fixed-rate period ends, an ARM's interest rate moves up and down with another interest rate, called the index. The index is an interest rate set by market forces and published by a neutral party. There are many indexes, and the loan paperwork identifies which index a particular ARM follows.
To set the ARM rate, the lender takes the index rate and adds an agreed-upon number of percentage points, called the margin. The index rate can change, but the margin does not.
For example, if the index is 1.25 percent and the margin is 3 percentage points, they are added together for an interest rate of 4.25 percent. If, a year later, the index is 1.5 percent, then the interest rate will rise to 4.5 percent.
Most ARM rates are tied to the performance of one of three major indexes.
Major indexes for adjustable-rate mortgages
Weekly constant maturity yield on one-year Treasury bill. The yield debt securities issued by the U.S. Treasury are paying, as tracked by the Federal Reserve Board.