| Adjustable-rate mortgages, known
as ARMs, differ from fixed-rate mortgages in that
the interest rate moves up or down. ARMs are tied
to a number of indexes, which usually are published
interest rates. The margin is the amount a lender
adds to the index , usually two percentage points
or four percentage points, to set the actual interest
rate of the ARM.
The most common index for ARM adjustments is
the one-year U.S. Treasury bill. The one-year
bill has a yield very near that offered by the
30-year Treasury bond, which is used to set rates
on 30-year fixed mortgages.
The initial ARM rate is generally lower than
the fixed mortgage rate, though in the current
economy the one-year ARM rate has been only slightly
lower, about one-quarter to one-third of a percentage
point. Check out the latest bankrate.com survey
of ARM interest rates.
Is an ARM for you?
If you plan to be in the house for less than five
years, it may be worth paying the lower interest
rate on an ARM vs. a fixed-rate mortgage.
It may be worth investing the difference between
an ARM payment and a fixed loan payment in mutual
funds and other investment securities.
If mortgage interest rates are high, you can
get a lower rate to start with and hedge your
bet that rates will fall in the future.
Some facts about ARMs
There are varieties:
• Some ARMs adjust the interest rate every
year, while others have an initial fixed rate
period of 3, 5, 7 or even 10 years, after which
the rate adjusts on an annual basis.
• The more short term the index that your
ARM is tied to, the more volatile your payments
will be. That’s good if interest rates fall,
but it can cause trouble if interest rates rise.
Most ARMS offer built-in caps to protect against
enormous increases in payments:
• Lifetime cap – Limits how much
the interest rate can rise during the life of
the loan.
• Periodic rate cap – Limits how much
your payments can rise at one time.
• Payment cap – Offered in some ARMs,
it limits the amount the payment can rise over
the life of the loan. So if the underlying index
rises, your payment would increase only to the
limit of the payment cap.
Keep in mind that rate caps work when the rates
rise and when they fall. To get a better understanding
of how ARMS work, we compare adjustable and fixed-rate
mortgages in the next section.
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