Quick answer: An ARM begins with an initial rate for a fixed period, then adjusts using the loan index, margin and contractual caps. Model the first adjustment and a higher-rate case instead of relying only on the introductory payment.
Identify the initial period, index, margin, adjustment frequency, periodic cap and lifetime cap in the loan documents.
A higher rate applied to the remaining balance and term can materially increase the payment after the fixed period.
Selling or refinancing before adjustment is not guaranteed. Include transaction costs and the possibility that future rates are unfavorable.
Next: read the ARM risk and rate guide, compare a fixed-rate payment, model a possible refinance.
When mortgage rates are high, Adjustable-Rate Mortgages (ARMs) surge in popularity because they offer a "teaser" rate that is significantly lower than a standard 30-year fixed loan. However, an ARM transfers the interest rate risk from the bank directly onto you.
An ARM is typically formatted with two numbers, such as a 5/1 ARM or a 7/1 ARM.
By law, lenders must protect borrowers from infinite rate hikes. They do this through three specific rate caps (e.g., 2/1/5 or 2/2/5).
The Golden Rule of ARMs: Before signing an ARM, you must calculate the exact monthly payment if the rate hits its Lifetime Cap. If you cannot afford that "Worst-Case" payment, you should not take the loan. Our calculator perfectly simulates this worst-case scenario.
Despite the risks, an ARM can be a brilliant financial maneuver in specific situations:
Understand the risks and rewards of an adjustable rate mortgage. See your initial payment, worst-case scenario, and fully indexed expected payment.
$3,648
Maximum Possible Payment
$2,690
Minimum Possible Payment
Your ARM has a 2/2/5 cap structure. At your first adjustment in year 6, your rate cannot increase more than 2%. Each subsequent year, it cannot change by more than 2%. Over the life of the loan, your rate will never exceed 11.00%.