An ARM is a mortgage with an interest rate that is linked to an economic index. The interest rate--and your payments--are periodically adjusted up or down as the index fluctuates.
You'll hear the following terminology when talking with lenders about ARMs.
An index is what the lender uses to measure interest rate changes. Common indexes used by lenders include one, three, and five-year Treasury securities, but there are many others. Each ARM is linked to a specific index.
Think of the margin as the lender's markup. It is an interest rate that represents their cost of doing business plus the profit they will make on the loan. The margin is added to the index rate to determine your total interest rate. It usually stays the same during the life of the loan.
The adjustment period is the period between rate adjustments.
You may see an ARM described with figures such as 1-1, 3-1, and 5-1. The first figure in each set refers to the initial period of the loan, during which your interest rate will be the same as it was on the day of closing. The second number is the adjustment period, showing how often adjustments can be made to the rate after the initial period has ended. The examples above are all ARMs with annual adjustments.
If my payments can go up, why should I consider an ARM?
The initial interest rate for an ARM is lower than that of a fixed rate mortgage (where the interest rate remains the same during the life of the loan). A lower rate means lower payments, which might help you qualify for a larger loan.
Other reasons to consider an ARM:
The possibility of higher rates isn't as much of a factor if you plan to be in the home for a relatively short time.
Do you expect your income to increase? If so, the extra funds may cover the higher payments that result from rate increases.
Some ARMs can be converted to a fixed-rate mortgage. However, conversion fees may be high enough to take away all of the savings you saw with the initial lower rate.
While you normally can't dictate which index a lender uses, you can choose a lender based on which index will apply to your loan. Ask how each index has performed in the past. Your goal is to find one that has remained fairly stable in economic downturns.
When comparing lenders, consider both the index and the margin rate being offered.
If the lender doesn't plan to sell your loan on the secondary market, you might be able to avoid the Private Mortgage Insurance (PMI) that's normally required when a buyer makes less than a 20% downpayment.