What is an Adjustable-Rate Mortgage?

How does it really work?

The Adjustment Period -  

For most ARM's, the interest rate and monthly payment change every year, every three years, or every five years. However, it is possible to see more frequent interest and payment changes. The period between one rate change and the next is called the adjustment period. Therefore, a loan with an adjustment period of two years is called a two-year ARM, and the interest rate can change once every two years. 

The Index -  

Most ARM interest rate changes have a relationship with the changes in an "index rate." These indexes tend to go up and down with the general movement of interest rates. Thus, if the index rate moves up, so will a person's mortgage rate and the person will more than likely have to make higher monthly payments. On the other hand, if the index rate goes down your monthly payment may go down as well. 

Lenders base ARM rates on many different indexes such as the one, three, or five-year treasury securities. Among the most common indexes is the national or regional average cost of funds to saving and loan associations. The borrower should always ask what index will be used and how often it will change. 

The Margin -  

For lenders to determine the interest rate on an ARM, a few percentage points called the "margin" are added to the index rate. The amount of the margin can differ from one lender to another, but it usually remains constant over the time length of the loan.

The "seller buydown" involves the seller arranging a discount with the lender. The seller will pay a certain amount to the lender in order to receive a lower rate and lower payments in the beginning of the mortgage term. In order to get the money for the buydown the seller can increase the sale price of their home. 

A lender may use a low initial rate to decide whether or not to approve the borrower's loan, based on his or her ability to afford it. The borrower should be very careful and always consider whether he or she will be able to afford payments in later years when the discount ends and the rate is adjusted back to a higher one.