Adjustable Rate Mortgages (ARMs) have been pretty popular lately in the media, but not necessarily in a good way.  This post is not going to address the media or repuation that surrounds these mortgage products.  Instead, it is going to inform you, the consumer, of what an ARM is and why the exist.  Then you can decide.

First, what is an ARM?  An ARM is a mortgage product that often has a fixed interest rate for a short term compared to the overall length of the mortgage term (typically 30 years).  Once the fixed period has lapsed, the interest rate then becomes adjustable and moves in relationship to the market.

Ok, so let's break that basic definition down.

1. "Fixed interest rate for a short term" - ARMs have different sub-products usually defined by a series of numbers. 2/28, 3/27, 3/1, 5/1, etc.  These numbers serve two purposes.  The first number tells you how long the interest rate is fixed.  2/28 is fixed for 2 years. 3/27 is for 3 years.  So on and so on.  The second number typically tells you when the rate will adjust and how many years the loan is ammortized over.  2/28 is ammortized over 30 years (2 fixed, 28 adjustable.) and will adjust every 6 months.  Now, the 3/1, 5/1, 7/1, etc. gets a little confusin.  First number is still fixed number of years.  Second number is when it adjusts, but does not tell you the term of the total loan (this is because the 40 and 50 year mortgages are new products and did not exist when these products were originally introduced.) These loans adjust every 12 months.
2. "Overall length of the mortgage term" - As mentioned above, the term length of a mortgage can vary.  In the past, 30 years was the norm.  Now, we have 40 and 50 year terms.
3. "Interest rate then becomes adjustable and moves in relationship to the market" -  The adjustments are based on two factors: Margin and Index.  Margin is a fixed rate charged by the lender. Index is a market driven rate that adjusts (thus the name of the mortgage product.)  These indexes are can be LIBOR, CMT, COFI, COSI, CODI, T-Bill, etc.  (For more information on these indicies, visit http://mortgage-x.com/) To calculate your fully indexed rate, you simply add the margin and index together.

Second, why do you want an ARM?  There are several reasons why one would use an ARM. Here are just a few:

1. Bad Credit - Borrowers with bad credit will typically be placed in a 2/28.  The reason is because these programs, on average, carry lower interest rates than any other product.  The helps with keeping the monthly payments low.  Also, it will give the borrower 2 years to improve their credit score to get a better rate at time of refinance.
2. Short term ownership - A borrower is going to only hold the property for a short duration.  Again, these products typically carry a lower interest than a traditional fixed rate mortgage.  Why pay more when you plan to own for less?
3. Future plans to add on or renovate - Lower interest rate is the issue again.  If a borrower knows he/she is going to refinance within a certain time frame, taking the ARM that meets that time frame to ensure the lowest interest rate is the best option.
4. Equity - Hopefully, equity has been increased during the fixed portion of the loan.  The borrower took advantage of the lowest rate possible if high LTV financing was previously used.  Now, the equity has brought the LTV lower and thus the borrower can now get a better, lower rate.

Third, what are some of the features of an ARM?  I will briefly touch these, as this is a whole other topic of discussion.

1. Interest Only - Most lenders now offer this feature with their ARMs.  Although, they do exist now on fixed rate mortgage, this feature is more common with the ARMs.  This feature allows a borrower to pay only the interest due.  No money is used to buy down the balance.  A borrower can pay to the balance at his/her own will.  If money is used to pay down the balance, the loan is re-ammortized to calculate the new interest due amount based on the new balance.  In essence, the required monthly payment has been reduced with the reduction of the balance.
2. Minimum Payment - This feature is often referred to as the Option ARM.  A borrower has at least 3 options for payment: a minimum (similar to a credit card minimum payment), an interest only, and a fully indexed.  This is all I cover at this time on this as it is a whole product in and of itself.

Fourth, how are you protected if rates go too far?  Simple answer... lenders have place caps on how much you rate can change.  There are adjustment caps and life of loan caps.  The rate can only go up or down so much with each adjustment.  And there is a maximum and minimum rate that can be charged over the life.

I will note that there is a 1 month and 6 month ARM.  These ARMs are typically not used by the average borrower.  These programs are often used by investors using short term financing strategies.

This is a general overview to ARMs.  If you have any questions or are interested in determining if an ARM is right for you, please contact your mortgage professional.