With interest rates edging up, you may be thinking of using an adjustable rate mortgage (ARM) to finance your real estate purchase. So let's identify what it is, what it does and if it might work for your financial situation.

What is an ARM? It's an adjustable rate mortgage--a type of conventional non-fixed-rate loan that adjusts based on fluctuations in the economy. It is tied to an index (an indicator of inflation); and the interest rate is usually calculated by adding the index (like Treasury securities or T-bills, etc.) to a margin (which is the lender's cost of doing business plus profit). In other words, the formula for calculating the cost of your adjustable rate mortgage would be: Index + Margin = loan's interest rate.

What are the pros of using an ARM?

1. The interest rate adjusts based on economic swings (so the rate could go down in times of low inflation);
2. ARMs typically have lower initial rates than fixed-rate conventional loans;
3. Usually give a higher profit to the lender, so the borrower can often get underwriting concessions on ARM programs.

What are the downsides to going with an ARM?

1. The interest rate adjusts based on economic swings;
2. Borrowers who have infrequent pay increases could find themselves financially burdened to make payment increases;
3. Special loan options (such as the ability to convert them to fixed-rate loans, called a convertibility option) could prove expensive if not chosen to meet the borrower's needs.

Do you fit the adjustable rate mortgage buyer profile? You may be a likely candidate for an ARM if you:

1. Will keep the house/loan only a short time (usually less than four years);
2. Don't need the security of a fixed-rate mortgage;
3. Expect that income increases will keep pace with payment adjustments;
4. Cannot qualify at fixed-rate loan market rates and/or want to purchase a home that is slightly out of your financial reach at this time;
5. Feel that inflation will remain under control (since payment increases are a by-product of increasing inflation);
6. Want the loan to have the ability to fluctuate downward with market changes in the interest rate.

The bottom line is to ask the lender to compare various loan programs you're considering in order to show you not only the upfront costs of purchasing, but the worst-case scenario your adjustable mortgage loan could hit during the life of the loan. If you're comfortable with that outcome, an ARM may be right for you!