Unlike fixed rate mortgages which have fixed rates for fixed maturities, ARMs have changing rates for fixed terms. ARMs became popular when interest rates were escalating and lenders no longer wanted to take the chance of lending at 4 or 5% and then seeing their costs of funds skyrocket to 10 or 12%.
When interest rates were steady for years at a time, traditional fixed rate home loans worked; when interest rates became unstable, banks started protecting themselves with ARMs.
ARMs are for thirty years typically, with interest rates changing during those thirty years. For any borrower, when the rate changes is usually more important than the term of the loan. Anyone who predicts he will live in his house for an extended period of time is better off trying to get a traditional fixed rate mortgage with a long maturity, even if the interest rate is higher.
The five year adjustable rate mortgage is usually the best type of ARM for borrowers. If you pick an ARM that changes its rate more frequently, you take a big chance on being hit by temporary spikes in the interest rate. If you obtain a mortgage at a low interest rate of 6%, you can keep this rate, but if you choose an ARM that adjusts frequently (usually cheaper in the beginning), you risk perhaps 8% rates over the long run.
If your ARM was adjusted annually, you would have the 6.5%, then 7%, then 7.5% rates, before they settled back down to 7%. Luckily, most ARMs have a version of top interest rate cap as an element of the agreement.
One of the most critical factors in the ARM you choose is how long you plan on staying in the house. If you only plan on being in it for a couple of years, your main worry will be what the initial rate on the ARM is. If you project being in a home for six or seven years, try to negotiate a seven year adjustment. However, reset periods of more than 5 years are not common.
You also have to know which benchmark is being used to set the rate: government bonds, the LIBOR, CDs or others. Each of these has advantages and disadvantages, based on the amount of time of the loan and the borrower’s perception of the future of interest rates and tolerance of fluctuating payments. Remember that if you have an ARM that resets frequently, your mortgage payment will change frequently.
This is not an ideal situation for most people, who have to live on a fixed budget.