ARM (Adjustable Rate Mortgage)

The key letter in ARM is A, and it stands for adjustable, as in Adjustable Rate Mortgage.  Most mortgages have a fixed interest rate. That means you pay 5% interest (or whatever your rate is) during the first year you have your mortgage, during the third year, and all the way to the final day you have that loan and can throw your big "We Paid it Off" party.

With an adjustable rate mortgage, your rate can change. 

Why would you want to get an ARM rather than a fixed rate mortgage? Well, maybe you like the element of surprise. More likely, you can save a few bucks at the start of the mortgage loan. If interest rates are expected to rise, you can get a better rate (at first) with an ARM than you can with a fixed rate mortgage. By the time your ARM rates go up and you have to pay more, maybe you'll have gotten that promotion at work. Lots of folks choose ARMs because they seem like a better deal on paper, but you'll want to run side-by-side comparisons to figure out whether they'll cost you more in the long run. You'll also want to make sure you can afford your home loan—even if interest rates go up. If you're just barely making payments now and your monthly mortgage costs go up $300, what are going to do? That's the sort of situation that causes people to lose their homes.

ARMs have a couple parts. They usually start with a low interest rate and have  a guaranteed period of time for that interest rate, so you know your interest rate won't go up right away. An ARM also usually comes with an index (like LIBOR) against which it is adjusted, a step up percentage (how much the interest rate will likely grow each period), and maybe a cap (the maximum rate it can be raised in a given period). That all makes sure that the rate won't balloon out of control.

Some ARMs are interest-only for the first few years. The monthly amount you pay is really low, but you're also not paying down the principal or the amount you borrowed. That means the total amount you owe to the bank is not going down any. The upside is that your payments will be affordable at first, and you'll have time to increase your income or get a great job (and hopefully give interest rates a chance to drop). 

Example

An ARM at a 3.75% guaranteed interest rate for the first 5 years, a .25% step up, and a 12% cap has a schedule that looks like this:

Bank consortia, which price mortgages, are usually smarter about the pricing of mortgages than Joe the Plumber. Yet there's always a guy who wins the lottery. What happens if the interest rate steps up at intervals of 1% instead of .25%?

Let’s compare this to a fixed rate 5.25% mortgage.

Notice, you are making a trade-off between low interest in the early years (ARM) and certainty in the later years (Fixed).