Tutorial on Selecting Among Different ARMs

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18 April 2006

If you are selecting an ARM in order to make the payment affordable, try to avoid the riskiest ones with initial rate periods of less than 5 years. If you are selecting an ARM because you expect to pay off the mortgage before the initial rate period is over, leave yourself a margin for error. If you expect to be out in 6 years, for example, take a 7-year rather than a 5-year ARM.

If you are out of your house before the expiration of the initial rate period, the initial rate is the only rate feature that matters. The index, margin and rate caps are not relevant if you avoid rate adjustments.

Some astute borrowers with long time horizons select ARMs indexed to Libor because they have low margins that are likely to result in lower average cost than FRMs over long periods. Since Libor indexes are highly volatile, such borrowers should be prepared for fluctuating payments. See my Libor Loan Tutorial.

Borrowers who want to buy as much house as they can select an option ARM, on which the initial rate holds for a month. It provides the lowest initial payment of any ARM, and also the greatest risk of future payment increases. See my Option ARM Tutorial.

While 15-year ARMs appear now and then, virtually all ARMs today are for 30 years.