With a fixed-rate mortgage, the interest rate stays the some during the life
of the loan. But with an ARM, the interest rate changes periodically,
usually in relation to an index, and payments may go up or down

Lenders generally charge lower initial interest rates for ARM’s than for a
fixed-rate mortgages. This makes the ARM easier on your pocketbook at first than a fixed-rate mortgage for the same amount. It also means that you might qualify for a larger loan because lenders sometimes make this decision on the basis of your current income and the first year’s payment. Moreover, your ARM could be less expensive over a long period than a fixed-rate mortgage- for example, if interest rates remain steady or move lower. Against these advantages, you have to weigh the risk that an increase in interest rates would lead to higher monthly payments in the future. It’s a trade-off-you get a lower rate with an ARM in exchange for assuming a little more risk.
Here are some questions you need to consider:
1. Is my income likely to raise enough to cover higher mortgage payments if interest rates go up?
2. Will I be taking on other sizable debts, such as a loan for a car or school tuition, in the near future?
3. How long do I plan to own this home? (if you plan to sell soon, rising interest rates may not pose the problem they do if you plan to own the house for a long time.)
4. Can my payments increase even if interest rates generally do not increase?


The Adjustment Period
With most ARM’s, the interest rate and monthly payment change every year, three years, or every five years or more. However, some ARMs have more frequent interest and payment changes. The period between one rate change and the next is called the adjustment period. So, a loan with an adjustment period of one year is called a one year ARM, and the interest can change once every year.

The Index

Most lenders tie ARM interest rate changes to changes in an “index rate.” These indexes usually go up and down with the general movement of interest rates. If the index rate moves up, so does your mortgage rate in most circumstances, and you will probably have to make higher monthly payments. On the other hand, if the index rate goes down your monthly payment may go down a lot too. Lenders base ARM rates on a variety of indexes. Among the most common are the rates on one, three, or five-year Treasury securities. Another common index is the national or regional average cost of funds to savings and loan associations. A few lenders use their own cost of funds, over which-unlike other indexes-they have some control. You should ask what index will be used and how often it changes. Also, ask how it has behaved in the past and where it is published.

The Margin
To determine the interest rate on an ARM, lenders add to the index rate a few percentage points called the “margin.” The amount of the margin can differ from one lender to another, but it is usually constant over the life of the loan.

Index rate + Margin = ARM Interest rate!
Let us say for example that you are comparing ARMs offered by different
lenders. Both ARMs are for 30 years and an amount of $265,000.
(all the examples used in this are based on this amount for a 30-year term.
Note that the payment amounts shown here do not include items like taxes or
insurance.) Both lenders use the one-year treasury index. But the first lender
uses a 2% margin, and the second lender uses a 3% margin. Here is how that
difference in margin would affect your initial monthly payment.

First Lender:
One year index = 2%
Margin = 2%
Arm interest rate = 4%
Second Lender:
One year index= 2%
Margin = 3%
Arm Interest rate =5%

In comparing ARMs, look at both the index and margin for each plan. Some indexes have higher average values, but they are usually used with lower margins. Be sure to discuss the
margin with your lender.