The recent rise in interest rates has caused home buyers to take a closer look at adjustable rate mortgages, or ARMs. A key advantage to an ARM loan is that it usually has a lower initial interest rate than a fixed-rate loan, allowing a buyer to qualify either with a lower income or for a larger loan. In exchange for the lower rate, the home buyer must bear a greater amount of interest rate risk.

An ARM is a loan whose interest rate is adjusted according to movements in rates in the financial markets. The rate and the adjustments are determined by an index rate plus a margin.

Suppose the current index rate is 6 percent and the margin is 2 percent. The interest rate used for calculating an ARM rate would be 8 percent, which is the sum of the two. The index rate is usually some common measure of interest rates available regularly in the newspaper and on the Internet.

There are many different types of ARMS. Some maintain a fixed rate for up to ten years before making any adjustments. Others may adjust the rate only one year or even one month after closing.

Most ARMs have caps on how much the interest rate can increase in any adjustment period and/or over the life of the loan. The caps may be different at different points in the loan.

For instance, an ARM that maintains the initial rate for five years may then adjust every year thereafter. The allowable increase after the first five years may be larger than the allowable increase in any of the later years.

ARMs with a long initial adjustment period are especially attractive to buyers who do not expect to stay in a home long. If a buyer has an ARM with an initial adjustment period of five years and stays in the house for only four years, there will not be any adjustments on the loan. The buyer enjoys the advantage of the lower initial rate without ever having to experience possible rate increases.

As a rule, the greater the amount of interest rate risk borne by the home buyer seeking a loan, the lower the initial interest rate will be. For instance, an ARM which adjusts after one year and then every year thereafter is likely to carry a lower initial rate than an ARM which does not adjust until the end of the fifth year. The home buyer with the loan that does not adjust for five years is receiving greater interest rate security and pays for such security in the form of a higher initial rate.

ARMs can save a home buyer money should interest rates decline. With a fixed-rate mortgage, the only way to benefit from a drop in interest rates is to refinance the loan, which is expensive. With an ARM, a drop in mortgage rates might lower monthly payments without the need to refinance.

A home buyer can get an idea about the possible volatility of an ARM by looking at a table showing the movements of the index over the previous ten years. Be advised that interest rates can be very volatile and unpredictable, and past experience does not necessarily indicate what could happen in the future.

Home buyers should also look at a worst-possible-case scenario of how much payments could increase under the caps set on the loan. The worst case may be very unlikely, but it will help in understanding the potential risk of the loan.

Many ARMs include initial discounts. The discount may allow a buyer to qualify for a loan more easily, but it also may result in a sizeable increase in the monthly payments at the first one or second adjustment periods. With a discounted ARM, find out how the payments might change even if interest rates stay constant.

For many people, buying a home represents the largest purchase they will make in their lifetime. If you are shopping for a new home, an adjustable rate mortgage could be an important financing option worth considering. Depending on your circumstances, an ARM could save you money and make your home more affordable.

Lenders are offering many different types of ARMs. As a result, it is easy to get confused. Adjustable rate mortgages are not for everyone, so do your homework and ask questions. What may sound attractive in the short term could cost you a lot of money in the future.

To learn additional information about ARMs and other types of mortgages, you may call Fannie Mae's Consumer Resource Center toll-free at 1-800-732-6643 (1-800-7-FANNIE). Information is also available on the Internet from a few different sources.

At www.homebuilder.com, you can find information by clicking on “Mortgage Center.” The Mortgage Bankers Association of America has a Web site at www.mbaa.org and consumer information about home mortgages can be found in the “Buying a Home” section. And Fannie Mae sponsors a Web site that can be accessed at www.homepath.com. The information about home mortgages can be found in the section called “HomeStarterPath.”

Jeff Betsill, owner of Jeff Betsill Homes, is president of the Home Builders Association of Midwest Georgia, which serves a membership of approximately 410 builders and associate members in Fayette, Coweta, Spalding, Heard and Meriwether counties.