I see ads for mortgages in my area. The initial rates seem really low, but I think that they might go up. Exactly what is an adjustable rate mortgage (ARM) and how do they work?
An adjustable rate mortgage is one for which the interest rate is subject to change. There are lots of different variations on how they work, but here's a general idea.
The interest rate on an ARM is usually fixed for a specified period -- one year, three years, five years, etc. During that period of time, the rate won't change, and your monthly payment to principal and interest won't change, either (how much you have to kick in for insurance and taxes, if any, can change, however).
After that initial period, the rate (and payment amount) can change. It may change only once, or it could change regularly (every year, three years, five years) thereafter. There is often a maximum amount by which the rate can change at one time, and a cap on how much the rate can change over the life of the loan.
The rate changes are related to changes in an index rate. The index rate has to be readily available and regularly published. The loan interest rate might also include a margin over the index. For example, if the index rate is 5.00% and margin is 2.5%, the loan interest rate would be 7.5%.
To "buy your business," some lenders may reduce the initial rate on a loan so it's lower than the index rate plus margin would call for, but the "discount" usually ends with the first interest rate adjustment. As you have suggested, the rate on an ARM can go up, particularly when the initial rate is "discounted." Depending on the individual terms of a loan, the change in rate can be fairly large, and can make what was once an affordable payment jump out of a borrower's reach. That can often be the case when a lender doesn't allow for payment increases when figuring out whether a borrower can afford a loan. When the payment amount increases, you may or may not be in a position to refinance your loan with a new fixed-rate mortgage loan.
If you are considering an adjustable rate mortgage loan, be very careful to read the information the lender is supposed to give you about how ARMs work. Be sure to understand how the rate and payments on the particular loan you are considering may change, and whether you'll be able to afford payments if the largest allowable increase is made after the initial rate period. Above all, ask the lender or your attorney to clarify anything that you don't understand.
ARMs have worked for a lot of borrowers. They have also caused severe financial distress for other borrowers.
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An adjustable rate mortgage is one for which the interest rate is subject to change. There are lots of different variations on how they work, but here's a general idea.