Adjustable-Rate Mortgages

• Adjustable-rate mortgages, also known as ARMs, feature interest rates that can increase or decrease based on one of several rate indices, such as the 12-month Treasury average index. This means that your payments may go up or down over the life of your mortgage.
  
  This differs from a fixed-rate mortgage, in which the interest rate stays the same over the life of the loan.
  
  ARMs usually have a period where rates are fixed, and that time period can vary between three to 10 years. After that period, the rate is adjusted to a variable-rate structure.
  
  

Interest Rate Caps

• Because you are more vulnerable to dramatic rises in your interest rates and payments with an ARM, interest rate caps are in place to limit the amount your interest rate can increase. The Federal Reserve Board notes that interest caps come in two versions. The first is a periodic adjustment cap, which limits the amount the interest rate can adjust up or down from one adjustment period to the next after the first adjustment. The second is called a lifetime cap. It limits the interest-rate increase over the life of the loan.
  
  

Why ARMs Are Attractive

• ARMs are particularly attractive to people because of the immediate savings they may earn. Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages. This can be an incentive to borrowers because they are taking on the risk of having a variable-rate payment when their rate is adjusted.
  
  The Federal Reserve Board says this makes the ARM easier on your pocketbook than a fixed-rate mortgage for the same loan amount. Your ARM could be less expensive over a longer period than a fixed-rate mortgage if interest rates don't increase.
  
  

Factors To Consider

• The Federal Reserve warns that a drop in interest rates does not always lead to a drop in your monthly payments. In fact, with some ARMs that have interest-rate caps, your payment amount may increase even though the index rate has stayed the same or declined, according to Mortgages Financings and Credit.
  
  With some ARMs that have interest-rate caps, the cap may hold your rate and payment below the amount to which it may have increased. Whatever the difference between what you paid in interest and what you would have paid without the cap will carry over to future rate adjustments, which is called carryover. According to the Federal Reserve, at the next adjustment date, your payment might increase even though the index rate has stayed the same or declined.