You're shopping for the lowest mortgage rates available.  If you're looking for a mortgage with adjustable rates, the lowest mortgage rates now can potentially cause problems later. Here's why.

Adjustable Rates: Why Are my Payments Going Up?

Adjustable rate mortgage loans (ARMs) are defined by the fact that the interest rate does not remain the same throughout the life of the mortgage. Depending on the terms of the loan, the initial starting rate may apply for periods ranging from one month to ten years. Once that period expires, the rate converts to an adjustable rate and what you pay is determined by several factors. Adjustable mortgage rates move with financial markets and are pegged to published financial indexes.  When these indexes increase, so do rates.

Adjustable Mortgage Rates, Caps, and Margins

Other components of ARMs include "caps" and "margins." Caps limit the size of a rate increase and can also limit how high a rate can go during the life of the loan. There are additional caps limiting how low a rate can go--these are usually called "floors." The margin of a loan is a percentage added to the index and represents revenue to the lender. Subject to any applicable caps, the margin plus the index equals your interest rate. This is also referred to as the "fully-indexed rate."

Example of a Mortgage Interest Rate Adjustment

Here is an example of what ARM interest rates can do when it's time for them to adjust. Mr. Borrower was granted an ARM that offered a fixed rate for three years and then converted to an ARM. His starting rate was 4%, the loan was based on the 6 month LIBOR index, and carried a 2% margin. On the day his rate is set to reset, the LIBOR is 3.48%. Adding the 2% margin to this rate equals a fully-indexed rate of 5.48%. Mr. Borrower will pay 5.48% on his loan until its next reset, when the rate will be recalculated.

Lowest Mortgage Rates Can Lead to Increasing Mortgage Amounts

In the interest of offering affordable mortgage loans, lenders developed loans that include extremely low monthly payments; sometimes the payment amounts aren't enough to cover the full principle and interest (P&I) payment. The shortage is added to the mortgage balance. As concerns about credit and home values escalate, lenders have largely ceased to offer these types of mortgage loans, but before deciding on the lowest rates and/or payment amounts, you'll want to be sure you're not getting a mortgage with negative amortization.

If you plan to sell your home soon, an ARM with a very low starting rate could be a good deal--you probably won't have the loan when the rates adjust higher. Considering the unpredictability of recent housing markets, however, it's good to build in some flexibility. If you're planning to sell your home within five years, you might want to shop for hybrid ARMs that won't reset for seven years, instead of an ARM that will change in five years.  Understanding all of your mortgage terms can help prevent problems if your plans change. Asking questions of potential mortgage lenders is a good way to understand mortgage rates and how they can adjust. If you're shopping for an ARM loan, you'll need to consider more than current interest rates.