Adjustable Rate Mortgages (ARMs) - Quick Tips About How They Work

Adjustable rate mortgages can be very different than fixed rate mortgages.
Sometimes people can use these terms interchangeably in casual conversation.

A loan that is "fixed" for 5 years and then becomes adjustable after that can be called:

a 5 year ARM (adjustable rate mortgage)
or a "5 year fixed" by someone else
The traditional mortgage loan was the 30 year fixed loan. The rate on the loan did not change at all over the course of its 30 year term. The interest rate on day 1 was the same as the interest rate on the last day.

This kind of loan gives you the security of a predictable payment.

There are traditionally two drawbacks to a fixed rate loan: higher rates and the fact that people move.

A 30 year fixed loan generally has a higher rate than a 1 year fixed loan. The longer a loan is fixed for, in general the higher the interest rate. In recent years the difference between these rates has narrowed a lot to where they aren't that different at all.

The second drawback is that people with a 30 year fixed are unlikely to live in the same property for 30 years. When they move they will need a new mortgage, and they will have to get what the prevailing mortgage rates are when they apply. It is usually not possible to have a mortgage that is portable and can be moved from one property to another. So when you get a 30 year fixed, remember that unless you stay put in that property for 30 years you will likely have another mortgage in the future at a different rate.

Adjustable Rate Mortgages Explained:

An adjustable rate mortgage generally behaves in the following way:

it is fixed for some initial period (it can be for 1 month, 5 years, etc.)
after the rate stops being fixed the loan then becomes "adjustable"
it usually adjusts according to an "index" which is published by a third party, such as the LIBOR index
the rate is usually the index plus a "margin" which is the lender's profit
as the index rises, your rates will rise with it
as the index lowers, your rates should fall with it
the interest rate can change at a timed interval - it can change once a month, once every 3 months, once a year, etc.
each time the loan changes there can be a "cap" that defines the maximum change allowed each time the interest rate changes
there usually is also a lifetime cap to protect you from spikes in interest rates - this is a form of protection
Why People Use Adjustable Rate Mortgages

Adjustable rate mortgages are usually used by people for the following reasons:

the mortgage rates are generally lower for adjustable rate mortgages than for fixed rate loans
people who expect to be in a property for a relatively short time frame - if you're going to live somewhere for 2 years, than a loan that is fixed only for 5 years may work for you