Adjustable Rate Mortgages

The adjustable-rate mortgage (ARM) is geared to homeowners who want to start with relatively low monthly payments.

ARMs come with interest rates that fluctuate over the life of the loan. For the first year or the first three years of the loan (depending on terms), ARMs begin with a relatively low interest rate tied to an index such as the federal government’s cost of funds index. That index varies from month to month, according to economic indicators. On either the first- or third-year anniversary (depending on the agreement), the mortgage interest rate is reset based on fluctuations in the index.

Typically, the agreement states that at the maximum, the borrower’s interest rate can climb 2 percent in any one year and 6 percent over the length of the loan. That maximum increase is known as the rate cap.

Because ARMs are usually fixed for one or three years, they appeal to owners who expect to live but a few years in their home.

Another form of ARM involves the two-step mortgage, in which the interest rate can be raised only once at the five- or seven-year mark.

Some borrowers might want to convert their ARM to a fixed-rate loan at some point. It’s best up front to ask the lender if that’s possible and if so, at what cost.