AdjustableRate Mortgage (ARM)
The previous lesson
covered the most common mortgage option  the
fixedrate mortgage. This lesson covers the second most common
mortgage option  the adjustablerate mortgage (ARM).
AdjustableRate Mortgage
The adjustablerate mortgage (also known as a
variablerate mortgage or as an
ARM) has the following attributes.
 The interest rate is not fixed; rather, it can increase or decrease over the
life of the loan, based on market conditions.
 The amount of change in the interest rate is often based on an index selected
by the lender (e.g., yields on oneyear or sixmonth U.S. Treasury securities).
Many adjustablerate mortgages have rate caps that limit
how much the interest rate can change. Most ARMs have
periodic caps and
lifetime caps. Periodic caps limit the increase from one
adjustment period to the next. Lifetime caps limit the
overall interest rate
increase over the term of the loan. Limits of 2 percentage points per year
and 6 percentage points over the life of the loan are typical.
Warning 
Some adjustablerate mortgages seem attractive because they
have very, very low initial interest rates. However, they may also have
very high lifetime caps or costly penalty fees
that make it expensive to refinance. It is easy for an unwary buyer to
commit to an ARM that he/she cannot afford after only a few rate adjustments. 
The table below shows how interest rates vary for different types
of adjustablerate mortgages (ARM's).
10/1 ARM 
 Fixed for 10 years (120 payment periods)
 Adjusts each year thereafter, until the loan is paid off.

7/1 ARM 
 Fixed for 7 years (84 payment periods)
 Adjusts each year thereafter, until the loan is paid off.

5/1 ARM 
 Fixed for 5 years (60 payment periods)
 Adjusts each year thereafter, until the loan is paid off.

3/1 ARM 
 Fixed for 3 years (36 payment periods)
 Adjusts each year thereafter, until the loan is paid off.

1year ARM 
 Fixed for 1 year (12 payment periods)
 Adjusts each year thereafter, until the loan is paid off.

Variations on the AdjustableRate Mortgage
Adjustablerate mortgages come in many other flavors. Here are a few.
 Convertible ARMs.
A convertible ARM is a type of adjustablerate mortgage that allows the borrower
to convert the ARM to a fixedrate mortgage within a specified time period.
Lenders often charge a premium for a convertible ARM, so you need to
find out the exact terms and costs in order to evaluate this
option.
 Twostep mortgages.
The twostep mortgage is a type of adjustablerate mortgage that "adjusts" one, and
only one, time. Typically, a twostep mortgage has one interest rate for the first
5, 7, or 10 years of the loan and a different interest rate for the remainder of the
loan. The lender sometimes has the option to call the loan due with 30 days notice
prior to the adjustment.
 Balloon loan ARMs. Like the
fixedrate balloon loan, a balloon loan ARM is paid off as a
lump sum (the balloon) before the loan is fully amortized. Unlike
the fixedrate balloon, however, the mortgage payment is not
fixed. It can vary from one month to the next, just like any other
adjustablerate mortgage.
 Interestonly ARMs. Like the fixedrate
interestonly loan, an interestonly ARM requires
only monthly interest payments. Like a traditional adjustablerate
mortgage, it often has an initial period when the interest rate is fixed,
followed by periodic adjustments. The main advantage of this loan is
its initial low monthly mortgage payments. The main disadvantage is
that it does not reduce the loan principal.
 Graduatedpayment mortgages.
A graduatedpayment mortgage offers a very low initial interest rate. Then, each year
over the first 3 to 5 years, the interest rate is increased. After that initial period,
the interest rate remains constant over the remaining term of the loan. Be
aware that the initial years of this loan are often characterized by
negative amortization.
AdjustableRate Mortgages: Dealing With Uncertainty
A key attribute of adjustablerate mortgages is uncertainty. At some
point during the term of the loan, the interest rate will change.
Further, the amount and direction of change is uncertain.
This uncertainty presents a challenge for mortgage analysis. How can
we estimate the total cost of an adjustablerate mortgage when we
don't know the future interest rate? Here are two ways to deal
with this challenge.
 Worstcase scenario. Even though we don't know
what the exact interest rate will be in the future, we may
know the maximum interest rate. The maximum rate is defined
by periodic rate caps and maximum rate caps. The worstcase
scenario assumes that the interest rate takes on its maximum
value in every payment period.
 Bestguess scenario. In this scenario,
the analyst makes a guess about the average interest
rate during the term of the loan. For the analysis, one
assumes that the average interest rate will be somewhere below
the maximum rate.
Each approach has advantages and disadvantages. Because the worstcase
scenario overestimates the true cost of an adjustablerate
mortgage, the home buyer will never be surprised by a
largerthanexpected bill. On the other hand, someone who uses
the bestguess scenario may generate a more accurate estimate of
the true cost of the mortgage, if he/she guesses right about the
average mortgage rate. However, there is always the danger of
guessing wrong and underestimating the true cost.
All of the examples on this website use the worstcase scenario
to estimate costs for adjustablerate mortgages.