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With the low mortgage rates available for awhile longer, homeowners are rushing to refinance. But while most people automatically pick the traditional 30-year fixed mortgage, the adjustable rate mortgage should also be considered before making the final decision.

Despite the often negative perception of ARMs, these loans are not only highly misunderstood, but also very helpful for a certain group of people. Basically it boils down to 3 things:

-Are you planning on staying in your house for less than 5 years? If so, a 5/1 ARM would be perfect since you’re going to sell before the ARM begins adjusting.

-Do you keep up with economic news and watch where mortgage rates are going? Since ARMs are based on LIBOR, being prepared for adjustments is necessary if you plan on keeping it during adjustments.

-Are you close to paying off your mortgage? If you can pay off your mortgage within a 5 year period, then an ARM may help you do that with a lower interest rate.

If you fall under some of the conditions listed above, the next step is understanding how ARMs work. For example, what does it mean to have a 5/1 ARM that has 2/2/5 caps?

5/1 means the ARM will have a fixed interest rate for the initial 5 years, with it adjusting once a year after that. The rest of the numbers refer to the highest your mortgage rate can adjust by. The first number (2 in our case) states the initial adjustment max or cap. Hypothetically, if you begin with a four percent interest rate, after the first year – the most you can adjust up by is two percent on your initial adjustment.

During the second year, the most you can adjust up by is another two percent. Lastly, over the life of the loan you would only be able to adjust up by one more percent if you maxed out the two previous adjustments (2% + 2% +1% = 5%) in this example, since the last number in the series is the number five.

Keep in mind that this example only addresses the max your ARM can adjust up. In the example above, the homeowner would begin at 4% interest rate, and the absolute highest the rate can adjust up (provided that they choose not to refinance) is up to 9% over the life of the loan. Currently, rates have actually adjusted down – giving homeowners a much lower rate for the past two years than what they initially began with.

Regardless of whether you choose to refinance into an ARM, it’s good to understand all of your choices before picking one that best fits your situation.

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