When interest rates are high and expected to fall, an ARM or Adjustable Rate Mortgage offers a lower initial interest rate than a fixed-rate mortgage and therefore lower monthly payments. If, however, interest rates continue to rise, the borrower may find himself in trouble. Sometimes the interest rate on an ARM may double in just a few years time. There is no guarantee. If the borrower plans to live in the home for only a short period of time, an ARM is often the best choice. If the interest rate of the ARM becomes similar to or higher than those of fixed-rate mortgages, it may be possible to refinance. These are some of the things the borrower must consider before choosing an ARM over a fixed rate mortgage and, as with other loans, there are certain things to ask the lender, because terms may vary.

Terms

One consideration is the “adjustment frequency”. The interest rate of an ARM may be adjusted monthly, yearly or at some other interval. It is important to ask the lender to define the specific adjustment frequency attached to this loan. In general the borrower would benefit more from a yearly interval, but that depends on another term. The “cap” is the limit placed on the amount the interest rate may be increased each adjustment period. The borrower benefits from a fairly long adjustment frequency and a fairly low cap, however the borrower must beware of “caps” on total monthly payments. An ARM which places a “cap” on the total monthly payment is called a “negative amortization loan” and while the monthly payment is kept low, interest may accumulate and be added to the principal. This can mean that after years of paying a monthly mortgage payment, the principal has increased beyond the initial amount borrowed.

Other Considerations

The “adjustment index” is the specific index that the interest rate of the ARM is tied to. Banks use different indexes, interest on certificates of deposit is one, and treasury bills are another. The borrower should find out exactly what index the offered ARM is linked to. The “margin” is the amount, expressed as a percentage, which is added to the “adjustment index” and equals the total amount that the interest rate may be adjusted per interval. For obvious reasons, it is important to compare the margins offered by different lenders. Finally, a borrower should compare the “ceiling” or the highest amount the interest rate may become, over the life of the loan.