Adjustable Rate Mortgages, or ARMs, differ from fixed rate mortgages in that the interest rate and monthly payment move up (or down) as market interest rates change.
Most Adjustable Rate Mortgages have an initial period where the interest rate is fixed, followed by a much longer period during which the rate changes at preset intervals. The rates charged during the initial periods are generally lower than the rates found on comparable fixed rate mortgages. Remember, lenders have to offer borrowers something to make it worth their while to assume the risk of higher interest rates in the future.
The initial fixed rate period can be as short as a month or as long as 10 years. One-year ARMs are the most common, though the so-called hybrid Adjustable Rate Mortgage has become popular in recent years.
These hybrid Adjustable Rate Mortgages -- sometimes referred to as 3/1, 5/1, 7/1 or 10/1 loans -- have fixed rates for the first three, five, seven or 10 years, followed by rates that adjust annually thereafter. (continued below)
After the fixed rate honeymoon, an adjustable rate mortgage fluctuates at the same rate as an index spelled out in closing documents. The lender finds out what the index value is, adds a margin to that figure, then recalculates what the borrower's new rate and payment will be. The process repeats each time an adjustment date rolls around.
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