An adjustable rate mortgage (ARM) is different from a fixed rate mortgage in many different ways. The most important difference is with a fixed-rate mortgage, the interest rate stays the same during the life of the loan. With an adjustable rate mortgage the interest rate changes periodically, usually in relation to an index, and payments may go up or down when the index goes up or down. Among the most common indexes are on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).

Banks and lending institutions usually charge a lower initial interest rate for ARMs than for fixed-rate mortgages. The initial interest rate period makes the monthly mortgage payments lower for an ARM than a fixed rate mortgage for the same loan amount. An ARM could also be less expensive than a fixed-rate mortgage over a longer period of time, depending on the type of ARM, especially for a 5/1 ARM, 7/1 ARM, 10/1 ARM.

One also has to weigh the risk that an increase in interest rates would lead to a higher monthly payment in the future. Like an investment, it’s a chance you take, you get a lower initial rate with an ARM in exchange for assuming more risk over the long run. You also have to make sure you have enough income to cover the mortgage payment if rates go up. In this recent housing bubble many people were given a 1 year ARM that couldn’t afford the monthly payments when the initial interest rate reset to a higher rate. If you plan to sell your home sooner than later, rising interest rates would be less of a concern.

The initial interest rate and payment amount on an ARM will remain in effect for a limited amount of time, depending on the type of ARM, which can range from 1 month to 10 years. For some ARMs, the initial rate period and payment amount can vary greatly from the rates and payments later in the loan term. Even if rates are relatively stable, your interest rate and mortgage payment could change. When brokers quote the initial rate and payment on a loan, ask them for the annual percentage rate (APR). If the APR is a lot higher than the initial rate, it is likely that your rate and payments will be a lot higher when the loan adjusts, even if general interest rates remain the same. Use our mortgage calculator to figure out what the monthly payments might be.

With most ARMs, the interest rate and monthly mortgage payment change every month, quarter, year, 3 years, or 5 years. The period between rate changes is called the adjustment period. For example, a mortgage with an adjustment period of 1 year is called a 1-year ARM, and the interest rate and payment can change once every year; a loan with a 5-year adjustment period is called a 5-year ARM.

Two parts make up the interest rate on an ARM. The index–a measure of interest rates and the margin–the extra amount that the bank or lending institution adds. Your monthly mortgage payments will also be decided on caps–how high or low your interest rate can go.

Since your mortgage rate is tied to an index, your rate will go up when the index goes up or down when the index goes down. Some ARMs do not adjust downward, so when applying for a mortgage be sure to get an ARM that adjusts downward, if you’re taking on the risk of the rate going up, you might as well benefit when the rate goes down.

There are caps to how much the rate can increase or decrease. There is a periodic cap–limits the amount the rate can go up or down from one adjustment period to the next. There is also a lifetime cap–limits the amount the rate can increase over the lifetime of the mortgage.

Besides the initial period an ARM, there are also different types of ARMs.

Hybrid ARM:

There are often3/1, 5/1 , 7/1 or 10/1 hybrid ARMs. These mortgages combine a fixed rate period and an adjustable rate period. The rate is fixed for the first few years then adjusts annually for the remainder of the loan. For example, on a 7/1 ARM the rate is fixed for the first 7 years then adjusts every year after until the mortgage is paid off.

Interest-only (I-O) ARM:

Allows one to only pay interest on the loan for a certain period of time, no principal payments are made. This lowers the monthly payments for the loan initially but the payments increase after the initial period, even if interest rates says the same because you stay paying down principal as well as interest. For example, on a 30-year mortgage loan with a 5-year I-O payment period, you can pay only interest for 5 years and then you must pay both the principal and interest over the next 25 years. Because you begin to pay back the principal, your payments increase after year 5. In addition, you are now paying back the principal in 25 years not 30, so that also increases the monthly mortgage payment.

Payment option ARM:

This type of mortgage has gotten a lot of people in financial trouble recently. A payment option ARM is an adjustable-rate mortgage that allows you to choose among several payment options each month. Including a payment of principal and interest, and interest only payment or a minimum payment. The last payment type is the most dangerious  because the amount of any interest or principal you do not pay will be added to the loan. This increases the principal amount you owe, your future monthly payments and increases the amount of interest you will pay over the life of the loan. In addition, if you pay only the minimum payment in the last few years of the loan, you may owe a larger payment at the end of the loan term, called a balloon payment.

An adjustable rate mortgage can be a very useful financial tool if used properly. These types of loans were originally designed for people who expected there income to increase substantially, enabling them to afford a more expensive home sooner. Unfortunately, ARMs were used incorrectly by large amounts over the past several years, giving the product a bad name. If you decide to take out an ARM be sure to do your due diligence and figure out which ARM bests fits your needs or contact a financial advisor to help guide you through this process.