Should you do an arm?

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If you have listened to the media recently or opened a newspaper, you know that interest rates are at historical lows right now. As I right this article, it is possible to get a 30 year fixed loan in the high 3's! Wow! If you are considering buying a home, or refinancing, now would definitely be a good time to do so from an interest rate perspective.
So why would ANYONE consider doing an adjustable rate mortgage when fixed rates are so low?  After all,  with a fixed rate you never have to worry about the payment changing on you. It is a good question and the reality is that many people should not consider it. If you know you are going to be in your home for an extended period of time, and are unsure of what your future holds, then a fixed rate is likely the best option for you.
Not everyone is in the same situation though. Again, as I write this article a 5 year arm is available in the mid to high 2's as opposed to the high 3's on a fixed rate. Here is an example:
$300,000 loan
3.75% 30 year fixed: $1389 per month
2.75 5/1 arm: $1224 per month
That is a savings of $165 per month or just under $10,000 over 5 years! That is fairly substantial.
So why do an arm? There is really only one very compelling reason to do an arm.  It is if you are confident you will be moving to a new home or relocating within the period of your arm where the interest rate can't change. For example, on a 5 year arm, that is 5 years. You cant take a fixed rate with you when you pay the mortgage off or sell your home! So, if you know you will be going elsewhere is the next 2 years, 3 years, 5 years or even 7 or 9 years, there may be an arm product that makes sense for you.
A mortgage where the interest rate is fixed for a certain period of time before it is able to adjust is known as a hybrid arm and those are by far the most popular arms because they allow you to get a fixed rate for a period of time but not necessarily for a full 30 years when you very well may not need that same mortgage for 30 years. The most common examples are 3 year arms, 5 year arms, 7 year arms, and 10 year arms. On a 7 year arm, your initial interest rate will be locked in for 7 years before it can change! That is a long time and may be more than enough time to meet your needs if you know that your life will change and bring you to new places within that amount of time. A 10 year is even longer! If you knew in 6 years for example you planned to move to a new state and you were fairly certain of it, why would you pay a higher rate to lock in your payments for 30 years? You would be paying a premium for time you dont need.
So, what happens after that fixed period? Your loan can adjust based on the market. Most hybrid arms these days are expressed as the fixed period/change frequency. For example, you may be able to do a 7/1 arm. That means it is locked in for 7 years and then can change one time per year every year thereafter. It doesnt mean it must go up, only that it could. I have an arm loan right now that is 3 years into adjustment and it has only DECREASED!

What will it adjust to? Normally what determines your new interest rate after your locked in period is an margin plus a specific financial index. It works much like your credit card which is likely prime + something (like 10). Your arm mortgage will be a margin (like 2 or 3 for example) plus whatever index you are tied to. The most common indexes are the libor and the treasury. You may even hear it expressed that way including as a 5/1 libor for example. This means it is a loan that is locked in for 5 years and can not change, then can change once per year to the libor plus whatever the margin you have on your loan is. If the libor is 3%, and your margin is 2, then your rate would adjust to 5%.
One final technicality to understand is that there are usually caps that control how much your loan can actually adjust. One common one is a 2-2-6. These 3 numbers are knows as the initial cap, the periodic cap, and the lifetime cap. That means that the very first adjustment your loan can not increase by more that 2% over your intiial interest rate (the initial cap). Then, it can't increase by more than 2% any adjustment period after the intitial adjustment (the periodic cap). Finally, it can never increase more than 6% above your initial interest rate for the life of the loan (the lifetime cap). So, while a 6% increase is substantial, that is the absolute maximum it could ever go up and that wouldn't even be an option until year 8 on a 5 year arm (because year 6 would be capped at a 2% increase, and year 7 would be capped at 2% above that). These 3 caps are often expressed in the name of the product. A common example of this is a 5/1 LIBOR 2-2-6, or 10/1 TREASURY 5-2-5, etc.
There are definitely benefits to an arm and especially a hybrid arm for those that feel certain that their future will hold a change in their life. Using an arm can save you thousands of dollars while still giving you the security of a fixed rate for a pretty long time. Just make sure you ask the following questions:
1) What is my margin? (this will be added to the financial index when the loan is able to adjust)
2) What is my index? (probably the libor or treasury. This will be added to the margin when the loan is able to adjust. Research the history of the index so you understand what it looks like over a period of 20 years or so)
3) What are my "caps?" (how much can it change year one, each year after, and over the life of the loan)
Then, just compare the savings between one of these options and a fixed rate. If it makes sense, go for it! But, only if you are comfortable with it and it makes good financial sense for you.