How to choose an ARM Loan - You will usually have 4 choices of Adjustable Rate Mortgages(ARMs) offered: 3/1, 5/1, 7/1 and 10/1. The numbers used to describe the ARMs refer to the period for which the initial rate holds, and the rate adjustment period after the initial rate period ends. On a 3/1, for example, the initial percent rate holds for 3 years, then the rate adjusts annually. All these ARMs have annual rate adjustments after the end of the initial rate period.

Another critical factor to consider when choosing an ARM loan is, what are the annual caps and the lifetime caps of the ARM loan. In other words, is there a maximum rate that my loan can go up to or can it just adjust as high as possible each adjustment period and over the life of the loan. Most ARM's have an annual cap of 1-2%. This means that your rate cannot increase or decrease by more than 1 or 2 percent at any given adjustment period. Most ARM's have a lifetime cap of 6%. This means your rate cannot increase or decrease by more than 6% over the life of the loan.
Example: 3/1 ARM, start rate is 4.5% fixed for 3 years, there is an annual cap of 1% and a lifetime cap of 6% over the life of the loan your rate can never be higher than 10.5%, and each year your rate could never adjust more than a 1% increment. So at the time of your first adjustment your rate could not be higher than 5.5% or lower than 3.5%.

Typically the interest rate on an ARM is lower than the interest rate on a fixed rate mortgage. ARMs are a smart choice over a fixed rate if you do not plan on keeping the property for a long period of time.

Sometimes the relationship between ARM loans and Fixed Rate Mortgages(FRM's) can become inverted! This means a 5 year ARM (or a 3,7, or 10) could actually have a higher rate than a 30 Year Fixed Rate loan.

When choosing what ARM product is best for you make sure that you do not have a pre-payment penalty that is longer than the fixed period of your loan. You do not want to be in a 2 year ARM and have a pre-payment penalty that lasts for 3 years.

Real estate investors and buyers who value managing and maximizing their free cash flow may benefit fromthe pay option ARM adjustable rate mortgage program, which allows homeowners the option of deciding how much to pay on their mortgage each month.

When choosing among different Adjustable Rate Mortgages, it is as important to pay attention to the underlying indices as the margins. Some indices are more volatile than others and adjust more frequently.

If you know that you are only going to be in the home for a short period of time you should try to get a loan with a fixed term that is similar to that time period. For example, if you are planning on staying in the home 3 years, get a 3 year ARM. Most people don't stay in a home for 30 years, why get a loan that is fixed for that length of time?

One key thing when thinking of choosing an ARM loan would be to do some research on the various popular indices such as the LIBOR, MTA, COFI and COSI. Make sure you pick an index that is consistent with you plan for the mortgage. Be careful of lower margins, they are usually tied to a more volatile index. A good mortgage broker can help advise you in this regard.

You should discuss all the types of ARM mortgages being offered. Discuss the indexes and the margins. Make sure your comfortable with the ARM you choose.

If you do have an ARM with a prepayment penalty ask if it is a "hard prepayment" or "soft pre-payment" penalty. A soft pre pay will allow you to sell the house with no penalty. A hard pre-pay requires you to pay the penalty if you sell or refinance the mortgage before the pre pay expires. Pre pay panalties will vary in the amount required from 60 days interest to 6 months interest.

Every ARM loan is tied to a financial market index, such as CDs, T-bills, COFI or LIBOR rates. Your rate is determined by adding an additional percentage, refered to as a margin, to that index's rate. When the index rises or falls, your interest rate rises or falls with it. Make sure you know your ceiling interest rate or lifetime cap. This is a guarantee that your interest rate will never exceed a designated percentage. For instance, if your introductory interest rate was 5% and you have a lifetime rate cap of 6%(Meaning that your interest rate can never increase more than 6% during the life of the loan) then your lifetime cap would be 11%. Your interest rate could never exceed 11%, ever.

What Are the Benefits of an ARM?
A lower initial interest rate (usually 2% to 3% lower than fixed-rate mortgages)makes qualifying easier and the payments more manageable at first.
You may qualify for a larger loan than you would with a fixed-rate mortgage.
If you're only planning to stay in the home for a short time, the interest rate is likely to stay lower than that of a fixed-rate mortgage.
If you expect regular pay increases that would cover the increase in your interest rate, or you believe interest rates will fall, an ARM might be the wiser choice.

There are also two critical elements to consider when evaluating an ARM: the index and the margin. The interest rate you will pay at the end of the fixed period will be determined by the index at that time, which may adjust periodically, and the margin, which will remain fixed for as long as you remain in that loan.

Agressive monthly adjustables may be available for even lower monthly payment. These can make sense for short term ownership or investment properties.

How to Choose an ARM Loan
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