Most traditional home mortgages are those where the mortgage is repaid in equal installments for 30 years. This one-size fits all has been replaced for some with other alternatives. An adjustable rate mortgage, commonly called an ARM, is one example.

What is an ARM? It is a loan where the mortgage interest rates will change at some future time before the mortgage is fully paid off. There are several terms of the mortgage that are variable and which can affect whether you would want to have such a mortgage.

The initial interest rate - ARMs have a fixed rate for a fixed period before any changes can occur. Common initial periods are three, five, seven and ten years. After that, the rate can change at specific intervals, usually annually. A 5/1 ARM means that the initial period where home mortgage rates cannot change is for 5 years and the rate can change very year after that.

The index that determines the change -- future mortgage interest rates will be based on an index which determines the new mortgage payment. Common indices are the LIBOR rate (London Interbank Offering Rate -- a rate that governs lending between banks and represents a no-risk interest rate) or a rate based on long term US treasury bonds. In either instance the mortgage will have a future rate that is the index plus some additional amount.


Caps – future changes are generally capped to an annual limit and an overall limit. A common annual limit is a change of 1% up or down, so that the homeowner is not saddled with large changes when the mortgage becomes truly adjustable.

What are the advantages of an ARM to the homebuyer? Because the lender is not committed to an interest rate for 30 years, they do not have to be as concerned about future periods when prevailing rates are higher and their cost of funds would become higher as well. As a trade-off for this more secure future cash flow, the lender usually offers ARMs with lower mortgage interest rates than they are willing to offer for fixed rate mortgages. The initial rate is usually lower for an ARM than it is for a fixed rate mortgage. And that lower rate is guaranteed for the initial period of the loan. With a 5/1 ARM, the homeowner is guaranteed a lower mortgage payment.

Who does this help? A homeowner that knows they will only live in the home for a shorter period, say 6 years or less, will benefit from a 5/1 ARM. Their mortgage payment every month will be less. Further, a person that fully expects to be earning more money five years out will benefit from lower payments now, even though their home mortgage rates could be higher in the future, they will have more money to pay it.

ARMs can be a very useful tool for the homeowner that needs to get into home now with a lower mortgage payment.