What is an Adjustable Rate Mortgage?

An Adjustable Rate Mortgage, also known as an ARM is a mortgage that has an interest rate that could periodically alter or adjust, and is usually based on changes to the Treasury bill, LIBOR, or prime rate. The mortgage holder is protected through a maximum rate of interest or ceiling rate, which could be adjusted annually.

This kind of mortgage normally begins with better rates than a fixed rate mortgage to compensate the borrower the further risk of future interest rate fluctuations.

Two of the most common types of ARM's are the Hybrid and Interest only. Different types of ARM loans have varied effects on the payment each month as well as the interest rate and loan principal.

The Hybrid Adjustable Rate Mortgage Home Loan is the same as a mixture of the fixed rate mortgage and the ARM where rates remain the same for a predetermined number of years at the beginning of a loan. When the initial fixed rate ends, the loan balances earns a rate of interest that periodically adjusts to the market rates.

This type of ARM is frequently listed showing the initial fixed rate and the frequency it is adjusted like 3/1, 5/1, 7/1 and so forth. They could also be listed showing the initial fixed rate and the remainder adjustable rate like 3/27, 5/25, 7/23 and so on.

For example, for a thirty-year loan, a Hybrid ARM could be like this:

3/1 – The 3 means the fixed rate in years while the 1 means the yearly rate adjustment at the end of the fixed rate period.

3/27 - The 3 illustrates yearly fixed rates while the 27 is the remaining loan years in an adjustable rate.

If an ARM is listed like 3/27, this means that the rate of interest could be adjusted in six months time instead of yearly.

An interest only ARM permits a low monthly payment at the beginning of a loan. The years where you only pay for the interest can alter and in general could be from three to five years. At the end of the interest only period, the borrower or homeowner will begin to pay for the principal loan with a higher rate than a normal fixed rate mortgage.

The longer an interest only period means that it now has a higher payment for the principal loan every month at the end of the interest only period. For instance, the interest only period of five to ten years for a thirty-year loan has 25 years left for paying the balance of the principal amount. A ten-year interest only, there is twenty remaining years to pay the principal amount.

At the end of the initial period, the rate of interest of the loan balance may increase depending on the market forces. The combination of added principal and the added risk of a higher interest rate could add to a higher payment every month compared to an interest only payment. If a homeowner plans to keep the home beyond the initial interest only period, this type of ARM is not a good option.

The most important factor is that lenders are required to give you written information on the types of mortgages available to help you make an informed decision. Do not hesitate on asking questions in order to understand each and every aspect of an Adjustable Rate Mortgage, as well as any other type of loan offered to you.

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