Adjustable-Rate Mortgages (ARMs)
Another option you've got as a borrower is an ARM, a mortgage with a variable interest rate that is linked to a specific economic index, a guide that lenders use to measure interest rate changes. If the index goes up, so does your interest — and your payments. One, three, and five-year Treasury security indexes are often used as the basis for ARMs, but lenders can choose from many others.
ARMs are described using figures such as 1-1, 3-1, and 5-1. The first figure in each set refers to the initial period of the loan, during which your interest rate will be the same as it was on the day of closing. The second number is the adjustment period, which tells you how often adjustments can be made to the rate after the initial period has ended. Here are two examples:
A 1-1 ARM has an initial period of one year, with rates that can change annually.
A 3-1 ARM has an initial period of three years, with rates that can change annually.
Ask your lender to explain the different types of ARMs it offers.
Terms to Know Before ARM-Shopping
There are several terms that apply to adjustable-rate mortgages. It's a good idea to become familiar with them before you start shopping for a loan:
Margin: This is the lender's markup, an interest rate that represents the cost of doing business plus the profit on the loan. The lender adds the margin to the index rate to determine your interest rate. The margin usually stays the same during the life of the loan.
Buy-down: This is the fee that real-estate sellers sometimes pay to temporarily reduce the initial interest rate. Homebuilders often use buy-downs to offer their new homes at attractive interest rates. It's a good marketing method that you might want to use someday.
Adjustment period: This is the time between possible rate adjustments.
Interest-rate caps: Rate caps limit how much the lender can increase your interest rate. Periodic caps limit how much it can increase the rate from one adjustment period to the next, and overall caps limit how much the rate can increase over the life of the loan. Overall caps are required by law.
Payment caps: Payment caps limit the amount your monthly payment can increase at each adjustment. If an ARM has a payment cap, it probably won't have a periodic rate cap. The lender can carry over increases that would take a payment past the limit, implementing them at the next adjustment.
You can't choose which index a lender uses, but you can choose a lender based on which index will apply to your loan. Find a loan tied to an index that has remained fairly stable during various economic conditions. When you compare lenders, consider both the index and the margin rate that's being offered.