When financing a home, there are two major types of mortgage financing, a fixed rate mortgage and an adjustable rate mortgage (ARM). A fixed rate mortgage is a loan in which the interest rate does not change during the term. Conversely, with an adjustable rate mortgage, the interest rate is periodically adjusted during the repayment period. Typically, ARMs are readjusted based on market indices, such as Treasury securities.

Fixed rate and adjustable rate mortgages each have pros and cons. Fixed rate mortgages are in one way advantageous because the payment amount (principal and interest) does not change for the term of the loan (typically 15 or 30 years). This can help families keep within a budget. However an ARM can provide a lower payment, especially during the first few years of the loan. However, budgeting may be difficult, because, when the ARM rate changes, it can cause the monthly mortgage payment to skyrocket.

Some ARMs prevent the interest rate from rising within the first few years (sometimes called the adjustment period). Some ARMs also have “caps” to prevent borrower default. Some caps are essentially limits on the total possible rise in interest rate. Other caps are limits on the frequency of interest rate changes. Fixed rate loans do not include caps, as the interest rate remains fixed for the life of the loan.

ARMs can be useful if the owner plans to live in the home for a short period of time. For instance, if you plan on selling within five years, it would probably be advantageous to take a “5/1″ adjustable rate loan. The 5 refers to the initial interest rate term (5 years), and the 1 refers to a 1-year interest readjustment period. In other words, the interest rate will be recalculated, based on a market index, every one year. So, the owner of the house would enjoy a low fixed interest rate for five years, after which the rate would change (and likely increase). But, if the owner sells within this period, no extra interest payments will ever be made. If you plan to live in a house for five years and take out a fixed rate mortgage, your monthly expenditure will likely be more, since fixed rate mortgage interest rates are typically higher than the initial rates offered by ARMs.

While fixed rate loans are the “classic” mortgage in the United States, ARMs have gained some popularity. However, during the last few years, some buyers purchased homes with ARMs that had very low initial interest rates. When the interest rates went up and home values plummeted, many of these buyers found themselves “upside-down” in their mortgages. In other words, their homes were worth less than they owed. While ARMs are not evil, many of the so-called “predatory loans” made in the last few years were ARMs with low initial interest rates (sometimes referred to as “teaser rates”).