What is an ARM?

An adjustable rate mortgage, commonly abbreviated to the shorter ARM, is simply a loan where the interest rate changes periodically. This is in sharp contrast to a fixed-rate mortgage, where the interest rate stays constant throughout the life of the loan. With an ARM, the interest rate changes with relation to an index, and may go up or down depending on how the related index performs.

You may wonder why anyone would take the risk of getting an adjustable rate mortgage. After all, while there is a chance that interest rates will fall and you will end up with a lower rate down the road, there is also a chance your interest rate will increase. Why take that chance?

Many take the chance because lenders compensate them for the risk by offering lower initial interest rates. This makes an ARM easier on you financially in the beginning, allowing you to start with lower monthly payments. Choosing an ARM might also allow you to qualify for a higher loan amount. Lenders sometimes base their decisions on whether to extend a loan partly on your current income and the first year payments. Because initial payments are lower with ARMs, your total amount can be higher and you will still qualify for the loan.

Of course, these advantages come with the possibility that your rates will increase in the future. All ARMs have a cap on the total interest rate increase over the life of the loan, and some cap periodic interest rate increases, or monthly payments. Still, you should consider factors such as whether your income will rise enough in the coming years to afford an increase in payments, whether you will be taking on other debt in this period, and the length of time you plan to own the home.

Overall, the question is not whether ARMs are good or bad, but rather whether they are the right type of loan for you and your circumstances.