Adjustable rate mortgages, or ARMs, for short, are mortgages with interest rates that can change over time. These mortgages have an initial fixed rate for a period of time which will “adjust” at the end of that predetermined timeframe. Then, the interest rate will reset every year thereafter. These mortgage offer lower payments upfront, but can also lead to higher payments long term, based upon what happens to interest rates.

The interest rate of the mortgage will be tied to a specific index; the most common indices are LIBOR and the 1-year CMT, but the mortgage can be tied to just about any index out there, so it is important to understand what rate your loan will be tied to.

The initial interest rate will always be lower than prevailing interest rates on fixed mortgages. This is because the lender is passing the interest rate risk to the borrower. So, if interest rates go up over time, the interest rate on the mortgage will increase. Similarly, if interest rates go down over time, the interest rate on the mortgage could go down.

If you are interested in this type of mortgage, it is important to understand a few key concepts. The first is the interest rate margin. As I said before, the rate will be tied to an index, but your rate will not necessarily be the index – it will be some amount above or below that rate. So, if your rate were tied to prime, and you had a rate of prime + 1%, then your current interest rate would be 4.25% as of today (prime today is 3.25%). Depending upon what happens with prime, the next time your mortgage adjusts, your rate could go up, down, or stay the same.

Another important concept is the interest rate cap. The cap limits how high the interest rate on the mortgage may go. Similarly, there can be caps on how much the rate may change year over year or how much the mortgage payment may adjust annually.

Finally, you want to understand what negative amortization is. Negative amortization is when your monthly payment does not cover the full interest for the month, meaning your actual mortgage balance is increasing. This can happen if your interest rate goes up but your monthly payment is capped. It is rather uncommon in traditional ARMs, but it is something to look out for.

If you would like more information about adjustable rate mortgages and whether or not one makes sense for you, please contact me so that we can discuss your situation. And if you have anything to add about ARMs, please leave a comment.