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
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