An Adjustable Rate Mortgage (ARM) is simply a mortgage that offers a lower fixed rate for 1, 3, 5, 7, or 10 years, and then adjusts to a higher or flat rate after the initial fixed rate is over, depending on the bond market. I take out 5/1 ARMs because five years is the sweet spot for a low interest rate and duration security.
Fear of an excessive interest rate increase after the fixed rate period is over is the main reason why most homeowners take out a 30-year fixed mortgages. The other reason 30-year fixed mortgages are more popular is because banks have more wiggle room to earn a higher profit margin.
What’s important to realize is that there is a cap on how much the interest rate can increase during the initial adjustment period. There is also a lifetime cap on your mortgage interest rate if you decide to hold and not refinance. Finally, none of these caps may ever be realized if the 10-year Treasury bond yield or LIBOR doesn’t increase.
I’m a believer that interest rates will stay low for a long time. Therefore, taking out a 30-year fixed mortgage where you pay a 1% – 2% higher interest rate is suboptimal. Remember, ARMs are different from negative amortization mortgages where the principal balance increases rather than decreases over time. Let me use my latest 5/1 ARM mortgage refinance to explain.