Adjustable Rate Mortgages (ARMs)

Adjustable rate mortgages (ARMs) fluctuate with the market level of interest rates, then so does your monthly payment. Therein lies the risk: Because a mortgage payment is likely to be a big monthly expense for you, an adjustable-rate mortgage that is adjusting upwards may wreak havoc with your budget.

• People who are stretching themselves -- such as some first-time buyers or those trading up to a more expensive home -- may financially force themselves into accepting adjustable-rate mortgages. Because an ARM starts out at a lower interest rate, such a mortgage enables you to qualify to borrow more.
• Some homebuyers who can qualify for either an adjustable-rate or a fixed-rate mortgage of the same size have a choice and choose the fluctuating adjustable-rate mortgage. Why? Because they may very well save themselves money, in the form of smaller total interest charges, with an adjustable-rate loan rather than a fixed-rate loan.
• Because you accept the risk of a possible increase in interest rates, mortgage lenders cut you a little slack. The initial interest rate (also sometimes referred to as the teaser rate) on an adjustable should be less than the initial interest rate on a comparable fixed-rate loan. In fact, an ARM's interest rate for the first year or two of the loan is generally lower than a fixed-rate mortgage.
• Another advantage of an ARM is that, if you purchase your home during a time of high interest rates, you can start paying your mortgage with the artificially depressed initial interest rate. Should interest rates subsequently decline, you can enjoy the benefits of lower rates without refinancing.
• Another situation when adjustable-rate loans have an advantage over their fixed-rate brethren is when interest rates decline and you don't qualify to refinance your mortgage to reap the advantage of lower rates. The good news for homeowners who are unable to refinance and who have an ARM is that they probably already capture many of the benefits of the lower rates. With a fixed-rate loan, you must refinance in order to realize the benefits of a decline in interest rates.
• The downside to an adjustable-rate loan is that, if interest rates in general rise, your loan's interest and monthly payment will likely rise, too. During most time periods, if rates rise more than 1 or 2 percent and stay elevated, the adjustable-rate loan is likely to cost you more than a fixed-rate loan.

Before you make the final decision between a fixed-rate mortgage versus an adjustable-rate mortgage, you should consider the potential impact on your finances.

ARMs are also particularly advantageous for shorter-term ownership, when you think you'll sell in 5 years or less. Read the section on Length of Ownership.