By Jay Levitt, Guaranteed Rate

Most people have heard of ARM mortgages but aren’t sure exactly how they work. An Adjustable Rate Mortgage or ARM is a mortgage type in which the borrower has a fixed rate or "start rate" for an initial term (3, 5, 7 or 10 years typically), and then after the initial rate term is completed, the interest rate will start to adjust according to some regular predefined interval (like every 6 months, once per year etc.).

The beauty of an ARM is that typically the "start rate” for the initial term is lower than a long-term fixed rate (10, 15 or 30 year fixed for example). The downside of an ARM is that after the initial fixed rate term ends the rate can adjust on some regular basis, which means you may end up having a higher rate than you would have had with a traditional fixed rate product. Keep in mind, of course, that you probably enjoyed a lower rate for the initial fixed rate term of the ARM.

With today’s ARM programs, the terms of how often your rate will be subject to adjustment and how the newly calculated rate will be determined will specifically be spelled out for you. Typically, the new rate is calculated as a function of a financial index (like the LIBOR index for example) plus a "margin" that gets added to that index. The "margin" and "index" are part of the terms of the ARM product that you sign up for, so you know what these are from the get-go.

While you will not know today what the actual "index" number will be in the future, the terms of your of your loan will define certain “floors” and “ceilings” so that you will have some predictability as to the maximum your rate can increase or decrease on each adjustment and over the life of the loan. These pre-determined limitations are sometimes referred to as “rate caps”. You should understand these mechanics prior to originating an ARM type mortgage.

Many of my clients are comfortable with ARM products as long as they know they will not have the loan longer than the initial fixed rate term. Maybe they plan to sell the house or payoff the mortgage before the adjustment period, so enjoying the lower rate of an ARM is advantageous for them.

The other item I think is worth mentioning is that ARM's typically seem to become stylish when longer term fixed rates are rising (which is the case now). I must say there has been quite a run on ARM type loans these past few months.

As a general rule, I like to advise my clients to be cautious of ARM programs unless they are in a position to comfortably accept the worst-case scenarios that can result after the initial fixed rate term. Remember, it is possible to calculate the "worst case" scenarios prior to doing the loan since you will know what the "rate caps" are.

If you’re interested in finding out if an ARM loan is the right option for you, please call me at 1-800-413-6001 anytime. We can discuss the important components of ARM loans such as how payments are calculated. Always at your service, Jay Levitt at Guaranteed Rate.