An adjustable-rate mortgage (ARM) is a loan with an interest rate that changes. ARMs may start with lower monthly payments than a fixed-rate mortgage.
An adjustable-rate mortgage differs from a fixed-rate mortgage in many ways. Most importantly, with a fixed-rate mortgage, the interest rate stays the same throughout the life of the loan. With an ARM, the interest rate changes periodically, usually in relation to an index, and payments may fluctuate slightly up or down accordingly.
In general, you will be charged a lower initial interest rate for an ARM versus a fixed-rate mortgage. Initially, an ARM is easier on your pocketbook than a fixed-rate mortgage would be for the same amount. Your ARM could potentially be less expensive over a long period than a fixed-rate – for example, if interest rates remain steady or move lower.
How ARMs work:
- Initial rate and payment – The initial rate and payment amount on an ARM will remain in effect for a limited period – ranging from 3, 5, 7 or 10 years. For some ARMs, the initial rate and payment will vary from the rates and payments later in the loan term. If the APR (annual percentage rate) is significantly higher than the initial rate, it is likely that your rate and payments will be higher when the loan adjusts.
- The adjustment period – With most ARMs, the interest rate and monthly payment change every 3 years, 5 years, 7 years or 10 years. The period between rate changes is called the adjustment period. For example, a loan with a 3-year adjustment period is called a 3-year ARM.
- The index – The interest rate on an ARM is made up of two parts: the index and the margin. The index is generally a measure of interest rates and the margin is an extra amount that the lender adds. If the index rate moves up, so does your interest rate in most circumstances, and you may have to make higher monthly payments. On the other side, if the index rate goes down, your monthly payment could go down.
- The margin – To set the interest rate, lenders add some percentage points to the index rate, called the margin. The amount of margin is constant over the life of the loan.
ARMs have more aspects to them and can be harder to understand. If you are interested in an ARM, contact one of our loan experts and they can walk you through the details.
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