An adjustable-rate mortgage (ARM), as the name suggests, can fluctuate over the life of the loan. But, the changes have a structure and follow a formula. The most common form is a Hybrid ARM, such as a 10/1 or 7/6 ARM

The first number, 10, indicates the loan's interest rate will remain fixed for the first 10yrs of the loan, and the 1 indicates the frequency of change, i.e., every 12 months or 1 year thereafter. The changes are based on "the prime rate" or an index such as COFI or LIBOR (less common). A 7/6 ARM has a fixed rate for 7yrs followed by a changing interest rate every 6 months thereafter.

A fixed-rate mortgage, which has a set interest rate for the entire term of the loan, may sound safer, but it's also typically 0.5% to 0.75% more expensive. If you are only planning to stay for 10yrs, a 10/1 ARM could save you $2,500/yr based on your loan amount. Less than 10% of homebuyers choose an ARM but more than 40% have owned their homes for less than 10yrs. Therefore, there's a statistical opportunity for more homeowners to save by choosing the right product.

It's important for homebuyers to get familiar with the interest rate risks of an ARM. After the initial period of 5-10 yrs, the interest rate can adjust up or down based on the movement of the index. There is a maximum amount that the rate can adjust per change and in total (known as a cap) that depends on the specific terms of your loan.

The interest rate on an ARM is composed of two parts: the index and the margin. The index is the benchmark interest rate that the loan's interest rate is based on, while the margin is a fixed percentage added to the index to determine the interest rate. For example, if the index is 3% and the margin is 2%, the interest rate on the ARM would be 5%.

Sometimes ARMs can be more expensive than fixed-rate mortgages. In such cases, it is wise to go with the stability of a fixed-rate mortgage. This occurs because ARMs track short-term indices, which can rise rapidly, whereas 30yr fixed-rate mortgages are more closely linked to the 10yr treasury note. Please compare the cost of an ARM vs. a Fixed Rate Mortgage to understand if the (interest rate) risk is worth the (interest savings) reward.

Once you have carefully considered the terms and conditions of an ARM, including the initial rate, adjustment period, and caps on interest rate increases, you can make an informed decision to save on interest for the next 5-10 years. If you decided to stay past the initial period, you can also consider refinancing into a shorter 15yr fixed-rate mortgage.