Adjustable Rate Mortgages 

With an adjustable rate mortgage (ARM), the interest rate is fixed for a certain number of years. Afterwards, the rate goes up or down periodically based on an economic index, which lenders use as a benchmark for interest rate adjustments.

The initial fixed rate, or teaser rate of an ARM is usually lower than the rate of a fixed rate mortgage. After the initial period, the rate adjusts based on the rate index used by the lender. With every rate adjustment, the mortgage payment will change.

The amount of time between rate adjustments is called the adjustment period. Many ARMs have a one-year adjustment period, meaning that the interest rate will adjust every year. Because rate adjustments can be unpredictable, most ARM programs offer a rate cap that limits the amount the interest rate can increase each year or over the term of the loan. The term for most ARMs is 30 years.

Advantages

• The teaser rate keeps initial monthly payments low, which may enable homebuyers to consider a more expensive home than might be possible with a fixed-rate mortgage

• If interest rates go down, the homebuyer will have lower payments

• May be a good choice for homebuyers who relocate often or who plan to move after a few years (e.g. homebuyers in the military or those buying their first home)

• May be suitable for homebuyers planning to refinance within 5 to 7 years

  May be appropriate for homebuyers who like the initial payment stability but can afford later adjustments in interest

Disadvantages

• After the initial fixed rate period, the rate becomes adjustable and monthly payments could increase if interest rates go up

• May not be the optimal choice for homebuyers on a fixed income who may only be able to afford monthly payments during the low teaser rate period

• May not be the best choice for homebuyers who plan to stay in their home for longer than the teaser rate period