Adjustable-rate mortgages

Adjustable-rate mortgages (ARMs) have a variable interest rate. This means that the amount of interest you pay will change according to market forces.

In general, ARMs begin with a short period of time wherein the interest rate is fixed. The length of this phase varies, but the standard is one year. This fixed rate is relatively low, and is one of the main incentives for taking on this type of loan.

After the fixed rate expires, the rate usually changes periodically (yearly, in many cases). If interest rates go up in the market, people with adjustable-rate mortgages pay more. If market interest rates go down, they pay less.

While the specific terms of ARMs vary widely, many share common features. Some of these features are designed to protect the buyer from extreme market fluctuations. Some mortgages will limit how much the interest can rise; such limits are called caps. Some will allow borrowers to switch to a fixed-rate mortgage, although there is usually a penalty for such a switch.

There are a number of disadvantages associated with adjustable-rate mortgages. The largest is that this type of loan is extremely risky. Rates can rise substantially, meaning that the borrower pays much more interest (and a much higher monthly payment) than she initially assumed. Also, the inherent complexity of ARMs means that non-savvy borrowers can become easily confused.

Of course, certain buyers stand to benefit significantly from ARMs. Obviously, if market interest rates are projected to decrease, the financial risk is somewhat lessened. Moreover, ARMs provide an affordable way to finance a home for a short period of time.