Delilah was very happy when she received her pre-approval notification for a mortgage loan. In fact, her lender pre-approved her for $25,000 more than she needed to purchase her first home. Delilah is now in the process of finalizing the details with the lender before the settlement on her home. The lender has offered her a fixed rate mortgage as well as an adjustable rate mortgage. The rate on the adjustable rate mortgage is much lower than the rate on the fixed rate mortgage. Delilah is unsure about which loan to choose.

An adjustable rate mortgage, also referred to as an ARM, is quite different from a fixed rate mortgage. While a fixed rate mortgage offers a set rate throughout the duration of the loan term, an adjustable rate mortgage fluctuates from time to time, usually based upon an index of some type. As the interest rate for an adjustable rate mortgage fluctuates, so does the amount of the payments that are due from the borrower. Usually, with an adjustable rate mortgage, lenders offer a lower introductory interest rate for a specified period of time. After the specified period, the interest rate can change based upon the applicable index.

What is an example of a typical adjustable rate mortgage?

A lender may offer an adjustable rate mortgage, with a fixed interest rate for the first three years of the loan, followed by adjustments every year thereafter for the remainder of the loan term.

What are some of the indexes used in connection with adjustable rate mortgages?

Lenders use a wide variety of indexes in connection with adjustable rate mortgages, including Treasury Bill rates, the prime rate, the 11th District Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). Some lenders use their own indexes.

Questions to Consider before Choosing an Adjustable Rate Mortgage

  • What are some things I should consider in determining whether I want an adjustable rate mortgage?
  • How long do you plan to stay in the home?
  • What is the maximum monthly payment you can afford?
  • Can you convert the adjustable rate mortgage to a fixed rate mortgage?
  • What is the applicable index? How has the index fluctuated in the past?
  • What is the initial interest rate? How long is it in effect?
  • Is there a cap on the amount the interest rate can increase? Or, in the alternative, is there merely a cap on the amount the payment can increase? Can the amount of the outstanding debt increase as a result of the cap?
  • What is the cost of the loan to you, including closing costs?
  • Do you have an option to pre-pay the loan? If so, is there any cost to you for doing so?

Additional information is available by contacting:

U.S. Department of Housing and Urban Development

451 7th Street, SW

Washington, DC 20410