Eighty-eight percent of homebuyers finance their house, making their choice of home loan, or mortgage, almost as important as their choice of house. While an adjustable-rate mortgage is one of the riskier options, it's occasionally a money-saving choice under the right conditions. It's crucial that you understand how an adjustable-rate mortgage works before deciding whether this type of financing will work for you.

What Is an Adjustable-Rate Mortgage?

As the name suggests, an adjustable-rate mortgage has an interest rate that changes over time. The only number you're locked into is the initial rate. Your future interest rates are purely up to speculation at the time of your purchase, though some factors help you determine the worst-case scenario. A fixed-rate mortgage, on the other hand, maintains the same interest rate through the life of the loan, giving you predictability.

Introductory Rate Period
The allure of an adjustable-rate mortgage is its introductory rate, which is typically lower than those available with a fixed-rate mortgage. This rate lasts for a predetermined period, anywhere from a single month to 10 years. The specifics vary dramatically between mortgage lenders, so consider your options carefully.

If your introductory rate is locked in for a year or less, you must balance the initial benefits of the lower rate with the potential increase you'll soon face. If you have an introductory rate lasting for five to 10 years, however, you will enjoy greater benefits from this type of loan and may even find that you're ready to move again before the rate changes.

Determining Your Adjustable Rate
You should assume that your rate will increase each time it's adjusted with this type of mortgage. While you can't accurately predict each increase, you can determine the maximum rate you may face. Adjustable mortgage rates cap the interest at a certain amount. You'll notice three different caps that apply to your mortgage. The initial cap determines how much your mortgage can change during the first rate adjustment. The periodic cap applies to each period, typically every six months or once a year. Finally, the lifetime cap specifies the maximum change that can occur over the lifetime of the loan.

The Margin Rate & Mortgage Index
Following a major mortgage index like MTA, COFI or Libor will give you an idea of how your mortgage will change at the next adjustment period. Add your mortgage's margin rate to the index to determine your new adjustable rate. If the index drops, there's a chance your mortgage rate may fall. However, many lenders build an interest rate floor into their loans, which prevents the rate from falling any lower than the initial rate.

When considering a fixed vs. adjustable rate for your mortgage, take into account both the ARM's initial interest savings and the potential increases over time. It's essential that you understand the potential for fluctuation with this type of loan and plan accordingly so you're prepared to either pay the maximum adjustable rate or refinance in the future.

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