A adjustable rate mortgage (aka ARM) is one in which the rate fluctuates or adjusts over the life of the loan. Often the adjustable rate mortgage will come with a 2 or 3 year “fixed” rate and will only start to be variable when that first period of time elapses. The rate is tied to an index meaning it will fluctuate based on that index.

An index is a financial rate such as the Libor which is the London Interbank Rate or the rate at which banks exchange money with each other. This rate is more complicated than is worth trying to explain here, but there are limits on how high this variable rate mortgage can go. So, in the event you have this adjustable rate mortgage, and the Libor gets to 8% or 10% or even 15%, your exposure may be capped at 8%.

As an example of an adjustable rate mortgage, if you have an ARM that is fixed for the first couple of years at 5%, then begins to vary based on this Libor, you’ll most likely have a 2% above the Libor rate. So, if the Libor rate is at 3%, your rate would still be 5%. Your loan officer will explain this more in depth as well. Look for information also on how high it can get. Although the bank rate over the next 30 years may never get too high, you’ll want to know your maximum exposure and make sure that at whatever the higher rate may max out at, you can afford the payment at that level.

There are also limits on how quickly the rate can climb. For instances, if the Libor goes from 3% to 7% within a month, you are only obligated to adjust maybe 2% per month or over a given period of time as defined by the ARM, so your increase would not automatically be from 5% to 9% within that same month that the Libor adjusted. You’d have the increase over a multiple month period of time. Check the details of the ARM before you sign so you know what it is and how best it can be applied to your situation.

The adjustable rate mortgage is often a strategy some homeowners will use to get a lower rate while intending to refinance before the rate starts to adjust. This may be a good short term solution, but it’s a risk in that if you end up having some employment change or other circumstances change within that period of time, you’ll be stuck with whatever rates you get. Again, the nice part is that this type of mortgage rate has limits on the upper end (and usually the lower end as well).

With any Salt Lake City mortgage, you’ll have some risks involved. If you are planning to only be in a home for a short period of time (planned job change, etc), then the variable rate with a fixed for the first couple of years may save you some money. With this and any other mortgage, the percentage of each payment that goes towards the interest is significantly higher during the first few years of payments which means that if you are continually refinancing, your contribution towards the equity in your home is proportionally small versus staying in the same loan and allowing a greater percentage of each payment to go towards the principle.