An adjustable rate mortgage (or ARM) is a mortgage on the which the interest rate is periodically adjusted.  A number of factors can change the rate of an ARM resulting in the homeowner’s monthly payment going up.

Adjustable rate mortgages may seem like a good option because they may be less expensive than a mortgage whose interest rate is fixed, but they are riskier because the interest rate may go up during the term of the loan. Many ARMs also have an initial “teaser” period that features an even lower rate that is fixed for a short time (anywhere between one month and one year).  This may make the ARM seem even more of a bargain, but could result in higher payment increases in the long term.

If you are considering an adjustable rate mortgage keep in mind that your monthly payments could change and go up even if interest rates don’t go up.  Additionally, even if interest rates go down your monthly payment may not.  Also, be aware that ARMs often charge a penalty if you want to pay off your loan early.

ARMs can also result in negative amortization.  This means that the amount you owe may increase even if you make all your payments on time.  Negative amortization occurs when the monthly payment is not large enough to cover the interest due (because the interest rate has risen). The unpaid interest is then added to the principal on your loan so you will end up owing more than you originally borrowed.

If your are considering an adjustable rate mortgage you may want to ask yourself a few questions:

If interest rates go up will I be able to pay the higher rate at my present income?

How long am I going to stay in this home? 

Do I plan to pay off the loan early?

Arm Yourself with these ARM Questions
Here are some question you will want to ask your lender if you are considering an ARM:

• What is my initial rate and payment? (the starting interest rate and monthly payment on the loan)
  
  
• What is the Annual Percentage Rate (APR)? (if the APR on the loan is significantly higher than your initial rate then your rate and payment will probably be a lot higher when the loan adjusts)
  
  
• What is the Adjustment Period?  That is, how often will the rate and monthly payment change?
  
  
• What are the Interest Rate Caps?  This is the limit on your interest rate increase.  There are two types of caps.  The periodic adjustment cap is the limit your rate can go up or down in any one adjustment period.  The lifetime cap is the limit that your ARM can go up over the life of the loan.
  
  
• What is the Index Rate?  Put simply, what will your lender use to determine if your rate goes up or down?  Your rate may be tied to Treasury securities or funds rates or a combination of factors.
  
  
• What is the Margin?  These are the percentage points that the lender adds to the index rate to determine what your rate will be.
  
  
• What are the penalties if I want to pay off the loan early or make extra payments?
  
  
• Will I be allowed to convert the ARM to a conventional fixed-rate mortgage?

As with any loan, make sure you understand all the features and obligations of an adjustable rate mortgage before you sign on the bottom line.  If you don’t understand any part of the loan ask your lender questions under you fully understand.

The Federal Reserve has a handy worksheet for shopping for ARMS. You can find it by clicking on the link below:

Adjustable Rate Mortgage Worksheet