An ARM, or adjustable rate mortgage, is a type of mortgage loan which, after a certain initial period, does not always have the same interest rate as the day you signed the loan papers. The new rates that you have to pay after the initial fixed period may be higher or lower than your initial rate, although the fact is that they will almost certainly be higher because what makes ARMs attractive in the first place is their typical super-low initial interest rate.
ARMs work by having their interest rates tied to an economic index. There are ARMs for just about every index and there are many different types of ARMs, such as Interest-Only ARMs wherein, during the initial period, only calculated interest payments are made-nothing received paid against the principal during this period, making the initial period payments very, very low even on an expensive home.
ARMs are typically described in a pair of digits, like 3-1 or 7-1 or 5-6. The first number represents how long the initial period lasts: so here we have initial periods of three, seven, and five years. The second number describes how often the adjusting rate can adjust after the initial period is expired. Here, we have once a year, once a year, and once every six months, respectively. ARMs adjust periodically in accordance with the economic index to which they are tied, and that index in turn is adjusting all the time in relation to the market segment that it tracks. If you have your ARM pegged to a volatile index, your adjustments will be volatile.
ARMs also have caps. They may have periodic caps, which limit how far up (or down) your interest rate can adjust from one adjustment period to the next. Many ARMs have no such caps. However, they all do have overall caps, which defines the maximum that the interest rate can go up (but not down) during the life of the loan. These have been federal law since 1987. But, these maximum rate-hikes can still be fundamental.
People get ARMs for one of three reasons: they plan on selling the home within the initial period; they plan on refinancing into a fixed rate mortgage within the initial period; Egypt, they plan on things being much better for them financially in the future once the initial period is expired (either they are very confident that they are going to be making much, much more money then, or they expect a better market based on the index peg they have chosen). Unfortunately, the best laid plans of mice and men … mean that quite often, people do not do what they planned to do, or things do not go as they thought they would, and the end up stuck with suddenly huge ( for them) mortgage payments that they struggle to make-or, can not make-when that initial period expires. This is especially true for the Interest-Only ARMs.
If you choose an ARM, choose one with care, and never take one unless you are completely confident that by the time the initial period expires you will not have any reason to care about that.