An adjustable-rate mortgage (ARM) has an interest rate that changes based on changing market rates and economic trends. They usually offer an initial interest rate that is two to three percentage points lower than fixed-rate mortgages, but they don't offer the stability or assurance of a known mortgage payment in the years to come. If you don't expect to be in your home for many years, however, an ARM may be just what you need.
How often your interest rate adjusts is determined by the terms of the loan. You may choose a six-month ARM, a one-year ARM, a two-year ARM, or some other term. There is usually an initial period of time during which the rate won't change. This might be anywhere from six months to several years. For example, a 5/1 year ARM would mean the initial interest rate would stay the same for the first five years and then would adjust each year beginning with the sixth year. A 3/3 year ARM would mean the initial interest rate would stay the same for the first three years and then would adjust every three years beginning with the fourth year.
There will also be caps, or limits to how high your interest rate can go over the life of the loan and how much it may change with each adjustment. Interim or periodic caps dictate how much the interest rate may rise with each adjustment. For example, the terms of the loan may be that the rate can go up as high as one percentage point each year depending on the market. Lifetime caps specify how high the rate can go over the life of the loan. For example, the terms of the loan might specify that the rate cannot go up by more than a total of six percentage points.
The interest rates for ARMs can be tied to one-year U.S. Treasury bills, certificates of deposit (CDs), the London Inter-Bank Offer Rate (LIBOR), or other indexes. When mortgage lenders come up with their rates for ARMs, they look at the index and add a margin of two to four percentage points. Being "tied" to these index rates means that when those rates go up, your interest goes up with it. The flip side is that if they go down, your rate also goes down. Try this ARM calculator to see how your payments might change with an adjustable rate mortgage.
A balloon mortgage offers an initial interest rate that is lower than fixed-rate mortgages. It keeps this low fixed rate for five to seven years and then requires a "balloon" payment. The balloon payment is the final payment of the loan and pays off the entire balance.
Monthly payments are low because the payments for those first five to seven years are amortized at a low interest rate over the total length of the loan. If you plan on either selling your home, paying it off, or refinancing it before the balloon payment is due, then this type of mortgage is good deal.