What is an ARM Loan?

Readers: This is article 4 of 25 from my no-nonsense “Mortgage Basics” quick-reference series.

An adjustable rate mortgage, otherwise known as an ARM mortgage, is a home loan that uses the property being purchased as collateral. Unlike a fixed-rate mortgage where the interest rate never changes, an adjustable rate mortgage has a fixed rate for a limited introductory period that typically varies between three and ten years. After that, the interest rate fluctuates up or down for the rest of the loan term.

For example, a 3/1 arm sets your interest rate for the first three years, and then adjusts annually for the next 27, assuming a typical 30-year loan period. Other common examples include 5/1, 7/1, and 10/1 ARMs.

Since the initial interest rate for an ARM is almost always less than a fixed-rate mortgage, the monthly payments are less. However, that can change if interest rates rise significantly over the life of the loan.

ARMs may be a viable option for those who expect any of the following:

• Interest rates will fall in the future
• They’ll refinance before the introductory period expires
• Their future income will rise, thereby offsetting potential higher payments
• They’ll sell their home before the initial interest rate increases

On the other hand, you should avoid an ARM if:

• You’re risk averse
• You’re uncertain whether your income will be higher in the future

Photo Credit: GotCredit