Adjustable-rate mortgage: Just the basics

Adjustable-rate mortgages, or ARMs, have monthly payments that can move up and down as interest rates fluctuate.

Most have an initial fixed-rate period during which the borrower’s rate doesn’t change, followed by a longer period during which the rate changes at preset intervals.

Pros:

Generally, the initial interest rate is lower than on a comparable fixed-rate mortgage. After the fixed-rate period ends, the interest rate can go lower, so monthly payments can fall, too.

Cons:

After the fixed-rate period ends, the interest rate can rise, so monthly payments can go up, too. Interest rates are unpredictable, so you can’t predict what your payments will be in the future.

Adjustable rates start low

Interest rates charged during the initial fixed-rate period are generally lower than those on comparable fixed-rate mortgages. See how various loan rates compare with one another.

Fixed-rate periods

The most popular adjustable-rate mortgage is the 5/1 ARM: The 5/1 ARM’s introductory rate lasts for five years. (That’s the “5” in 5/1.) After that, the interest rate can change every year. (That’s the “1” in 5/1.) Some lenders offer 3/1 ARMs, 7/1 ARMs and 10/1 ARMs.

ARMs follow rate indexes and margins

After the fixed-rate period ends, an ARM’s interest rate moves up and down with another interest rate, called the index. The index is an interest rate set by market forces and published by a neutral party. There are many indexes, and the loan paperwork identifies which index a particular ARM follows.

To set the ARM rate, the lender takes the index rate and adds an agreed-upon number of percentage points, called the margin. The index rate can change, but the margin does not. For example, if the index is 1.25 percent and the margin is 3 percentage points, they are added together for an interest rate of 4.25 percent. A year later, the index is 1.5 percent, then the interest rate will rise to 4.5 percent.

Major indexes for adjustable-rate mortgages

Weekly constant maturity yield on one-year Treasury bill. The yield debt securities issued by the U.S. Treasury are paying, as tracked by the Federal Reserve Board.

■ 11th District cost of funds index (COFI). The interest financial institutions in the Western U.S. are paying on deposits they hold.

■ London Interbank Offered Rate (Libor). The rate most international banks are charging each other on large loans.

Sky’s not the limit

You’re insulated from huge year-to-year increases in monthly payments because ARMs come with caps limiting the amount by which rates and payments can change.

Caps come in several forms:

■ A periodic rate cap limits how much the interest rate can change from one year to the next.

■ A lifetime rate cap limits how much the interest rate can rise over the life of the loan.

■ A payment cap limits the amount the monthly payment can rise over the life of the loan in dollars, rather than how much the rate can change in percentage points.