How an adjustable-rate mortgage works

Shopping for an adjustable-rate mortgage requires more than just looking at the introductory interest rate. Here are some of the basic things you'll want to understand about the way rates change on adjustable-rate mortgages.

ARM caps

Adjustable-rate mortgages have caps on how much the interest rate can go up. They include:

• Initial adjustment cap: The maximum amount the rate can increase the first time it is adjusted.

• Subsequent adjustment cap: The maximum amount the rate can increase at each adjustment thereafter.

• Lifetime adjustment cap: The maximum amount the rate can go up during the loan term, or the number of years it will take to pay off the mortgage.

For example, a 5-year ARM typically has:

• An initial adjustment cap of 2 percentage points.

• A subsequent adjustment cap of 1 percentage point.

• A lifetime adjustment cap of 5 percentage points.

If the introductory rate was 5%, the interest rate could go as high as 7% after the first adjustment at the 61st month, then 8% at the second adjustment six months later, with a maximum rate of 10% if rates continued to rise. This describes a worst-case scenario, which wouldn't necessarily happen. It's also possible that the interest rate could fall.

When considering an ARM, check the caps and calculate how much your monthly mortgage payment could increase. Would you be able to afford the mortgage payment if the interest rate rose to the cap? That's a good question to ask — even if you think you'll move and sell the home before the introductory period ends. Life has a way of disrupting plans.

Other ARM terms

Here are other terms to know when comparing ARMs.

• Index rate: The benchmark rate lenders use for ARMs. The index rate changes over time.

• Margin: A number of percentage points that your lender adds to the index rate to arrive at the interest rate that you pay during each adjustment period. The margin doesn't change.

• Introductory or teaser rate: The interest rate you pay during the loan's initial fixed-rate period.

• Change frequency: How often the rate adjusts after the introductory fixed-rate period.

Advantages and disadvantages of ARMs

In the first years of the loan, adjustable-rate mortgages usually deliver lower monthly payments than fixed-rate mortgages. In some cases, the interest rate and monthly payments can decrease.

On the other hand, the interest rate and monthly payments on an ARM can also go up. ARMs are harder to understand than fixed-rate mortgages and require the borrower to pay attention to what's happening to overall interest rates.

Regardless of which type of loan they have, borrowers may refinance their mortgages to take advantage of lower interest rates. And homeowners with ARMs may refinance into fixed-rate mortgages if they want to switch to a loan with an unchanging interest rate.

» MORE: Pros and cons of an adjustable-rate mortgage

When an adjustable-rate mortgage makes sense

Here are some scenarios when an ARM might be a good choice.

1. You're not buying a forever home. If you move in several years, an ARM could save you money. You'd benefit from the low introductory fixed rate, then sell the home before the adjustable period started.

2. You plan to pay off the mortgage quickly. Say, for instance, you expect a financial windfall, such as an inheritance. With an ARM, you would save money with the low introductory fixed rate and then pay off the balance altogether with the windfall. Ideally, the money would come in before the fixed-rate period ended.

3. You want initial low payments and are comfortable with the risk of higher payments later. There's also the possibility of the benchmark index dropping, which would mean your rate would decrease after the fixed period. But don't count on it. No one can accurately predict where interest rates will be years from now.