Rating:  Medium to High Risk.  Risk can be mitigated by selecting longer initial fixed rate periods.

Description:  Adjustable Rate Mortgages, also called “ARMs”, typically have a term of 30 years.  Unlike traditional 30 year fixed rate mortgages, the interest rate adjusts periodically after an introductory fixed rate period.  For Fannie Mae and Freddie Mac conventional mortgages, the introductory rate is typically fixed for 3, 5, 7 or 10 years.  Community Banks & other Portfolio Lenders often offer additional introductory rate periods of 1 or 2 years and shorter terms such as 15 and 20 years.

For Example: A conventional Fannie Mae 3 year ARM is a 30 year mortgage where the interest rate is fixed for the first 3 years of the loan, and then adjusts periodically– either monthly, semi-annually, or annually for the remaining life of the loan.

Generally speaking, the shorter the introductory fixed rate period, the lower the interest rate.  Therefore a 3 year ARM would have a lower interest rate than a 5 year ARM, and a 5 year ARM a lower rate than a 10 year ARM.  Almost all Adjustable Rate Mortgages offer lower initial rates than traditional 30 year fixed mortgages.  This makes ARMs attractive to people looking for a lower monthly payment in situations where they are not concerned about the risk of the monthly payment adjusting and potentially increasing once it enters the adjustable rate phase of the loan.  

Examples of situations where opting for an ARM might make sense include:

• You plan on being in the home for a short period of time & will sell the property before the introductory rate period expires.
• You plan on paying off the loan before the introductory rate period expires.
• You have a high probability of increasing income, ie. a radiology resident currently earning $40,000 annually but who upon graduating from the program will earn $250,000+ annually and will be aggressively paying down the loan over time or are not concerned about being able to make higher payments if the rate adjusts upwards and your payment increases.
• You would like a lower initial interest rate in order to qualify for or your mortgage.  7 year and 10 year ARMs qualify the borrower off of the initial fixed rate, which may make the difference between getting approved of denied for a loan if your debt ratio is tight.
  
  

If you are considering an Adjustable Rate Mortgage, you will want to determine what happens once your introductory fixed rate period ends.  You should inquire about the following:

1. When does my introductory fixed rate period end?
2. How often does the interest rate adjust after the introductory fixed period ends?
3. How much can the rate adjust per year?
4. How much can the rate adjust over the life of the loan?  (The max rate).
5. How do you calculate what the rate will adjust to?
   

To answer #s 2 – 5, you will need to understand what the following terms: Index, Margin, and Caps.