The most common types of home loans are fixed rate mortgages - where the interest rate and monthly payment are the same for the entire term of the loan. With an Adjustable Rate Mortgage loan (a.k.a. 'ARM loan'), the interest rate is subject to change at predetermined intervals - which can affect the monthly payment amount.

What are the Interest Rates on ARM Loans?

Lenders will often offer a low introductory rate for an initial period for ARM loans (i.e. 1 year, 3 years, 5 years). This rate is typically lower than the interest rate charged on fixed rate loans - which means the monthly loan payment will be lower in the early stages of the loan.

How ARM Loan Rates are Calculated After Introductory Period

Once the introductory period is over, the interest rate on an ARM loan will adjust periodically for the remainder of the loan (usually every year). The interest rate on many adjustable rate mortgage loans are based on the interest rates that the government pays for its loan obligations - Treasury Bills and Treasury Notes. Other adjustable rate mortgage loans are tied to the London Interbank Offered Rate (LIBOR) - the interest rate that large banks charge each other for short-term loans. A lender will use one of these 'index' rates for the first part of calculating the rate on ARM loans for its customers. To determine the rate it will charge on ARM loans at any given time, the lender will take the prevailing value of the index rate, and add its own margin (i.e. 2%, 2.5%). The lender will tell you what its margin will be when you apply for the loan.

How ARM Loans Can Increase Borrowing Power

Depending on the current level of interest rates, using an ARM loan can increase your borrowing power. The interest rates on fixed rate mortgage loans are based on longer-term interest rates. The interest rate on ARM loans are based on shorter-term interest rates. At times economic conditions cause the gap between short-term interest rates and long-term interest rates to be large. When these economic conditions occur, a lender will be able to qualify you with a lower interest rate using an ARM loan - which can allow you to borrow more money.

Why ARM Loans are not for Everybody

While getting an adjustable rate mortgage can allow you to qualify for a larger mortgage and offer payment savings in the early stages; they are not a good fit for everybody. Economic conditions can cause interest rate levels to change drastically from year-to-year, which means the index used to calculate ARM loan rates could rise sharply each year. Lenders will put a cap on the amount that ARM loan rates can change yearly (i.e. 2%), but many borrowers still may find it difficult to budget for the increased loan payment that could result from rising interest rates.

Since there are many factors to consider with adjustable rate mortgage loans, it is best to consult with a mortgage lender to see if can save you money and is a good fit for you financially.