What is the difference between a fixed-rate and adjustable-rate mortgage (ARM) loan?

Tip

Don't assume you'll be able to sell your home or refinance your loan before the rate changes. The value of your property could decline, or your financial condition could change. If you can't afford the higher payments on today's income, you may want to consider another loan.

Many ARMs will start at a lower interest rate than fixed-rate mortgages. This initial rate may stay the same for months, one year, or a few years. When this introductory period is over, your interest rate will change on a regular interval, and the amount of your payment is likely to go up.

Part of the interest rate you pay will be tied to a broader measure of interest rates, called an index. Your payment goes up when this index of interest rates increases. When interest rates decline, sometimes your payment may go down, but that is not true for all ARMs. Some ARMs set a cap on how high your interest rate can increase at any time or over the life of the loan. Some ARMs also limit how much your interest rate may decrease at any time or over the life of the loan. The caps may be different for the initial change versus the subsequent regular interval changes. Your actual rate and the time of change will be based on the new index plus a set margin, subject to any caps. The margin is a number of percentage points added to the index by the lender that sets your interest rate.

Know how your ARM adjusts. Before taking out an adjustable-rate mortgage, find out:

• How high or low your interest rate and monthly payments can go with each adjustment
• How frequently your interest rate will adjust
• How soon your payment could go up
• If there is a cap on how high your interest rate could go
• If there is a limit on how low your interest rate could go
• If you will still be able to afford the loan if the rate and payment go up to the maximums allowed under the loan contract

If you're shopping for a mortgage, visit Buying a house, our set of tools and resources for homebuyers.

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