Adjustable-rate mortgages, or ARMs, may sound risky -- after all, your payments can increase or decrease based on interest rates, which are out of your control. However, in some cases, choosing an ARM over a fixed-rate mortgage could be a solid financial decision, potentially saving you thousands of dollars.

What is the difference between fixed-rate and ARMs?
A fixed-rate mortgage is just what it sounds like: Your interest rate stays exactly the same during the life of the loan. With an ARM, the interest rate can change periodically based on the market.

For this reason, some people believe that fixed-rate mortgages are always the better choice no matter what. However, ARMs can be a good option for homebuyers who know they will be in the loan for only a few years, says Don Maxon, a certified financial planner in San Rafael, California.

This is because ARMs tend to come with a significantly lower starting interest rate and monthly payment compared with fixed-rate loans, according to Maxon.

"ARMs can make sense for customers who know they will be relocating in the near future or they know they will be paying off the loan in a few years, maybe [because of] retirement or expected inheritance or other receipt of funds," Maxon said.

The different types of ARMs
Hybrid ARMs: This type of ARM comes with an initial fixed-rate period, with the interest rate adjusting annually afterwards. The fixed-interest period can be anywhere from three to five, seven, or 10 years, and the interest rate tends to be lower on the shorter periods. For example, a 7/1 hybrid ARM would have a fixed rate for the first seven years and then adjust annually.

Interest-only ARMs: On an interest-only ARM, you'll pay only the interest on the mortgage for a certain number of years, not the principal. This gives you a smaller monthly payment for that period. The interest-only period tends to be anywhere from five to 10 years. For example, a 10/1 ARM would come with interest-only payments at a fixed rate for 10 years, and then it readjusts annually.

After the initial interest-only period, the loan amortizes so the mortgage is paid off by the end of its term. You should be careful, because this could lead to much higher monthly payments, even if the interest rate stays the same.

Payment-option ARM: This mortgage allows you to choose between several monthly payment options: an interest-only payment, a minimum payment, or a 15-, 30-, or 40-year fully amortizing payment. This gives the borrower more flexibility to make one of several payment options on the mortgage every month.

You can end up saving big money during the initial fixed-rate period on hybrid ARMs.

For example, First Internet Bank is currently offering a 5/1 ARM with an APR of just 2.872%, fixed for the first five years. On a $240,000 mortgage with $60,000 down, the total monthly principal and interest payments amount to just $996. Over the first five years, you'd have paid off $27,114 in principal.

If you were to get a 30-year fixed rate mortgage with an APR of 4.3%, your total monthly principal and interest payments would be $1,187.69, or $191.69 higher than the ARM. Over the first five years of the mortgage, you'd end up saving $11,501.40 in principle and interest payments by going with the ARM.

As you can see, the person with the 5/1 ARM saves $11,501.40 on monthly principal and interest payments, but that person also paid off $5,052 more toward the principal. If this person plans on staying in his or her home past the fifth year, the person may choose to refinance the 5/1 ARM into a 30-year fixed, or he or she might be planning to sell the house.

"The reason the initial ARM rate is lower than a fixed rate is because, for a fixed rate loan, the lender is taking all the interest rate risk," Maxon said. "However, if the customer knows that he or she will be selling the home within, say, five years, the five-year fixed rate loan could be an excellent option."

Some ARMs come with an interest rate cap, which places a limit on how much your interest rate can increase. You need to find out if your ARM has a periodic adjustment cap, which limits the amount the rate can adjust from one adjustment period to the next, or a lifetime cap, which limits the interest rate increase over the life of the loan.

For example, an ARM might come with a periodic adjustment cap of 7%. If you have an initial fixed-rate period of 4% for the first year, and then interest rates skyrocket to 13%, you would pay only the 11% since it's capped. Or your mortgage may come with a lifetime cap of 5%, so if your mortgage starts out at 4% APR, your interest rate can never exceed 9%. This limits your long-term risk of rising interest rates.

If interest rates move higher after the initial rate period, your payments would also increase. If you aren't ready for it, this could lead to "payment shock" and, in a worst-case scenario, result in default. This is a big risk you take if you plan on living in your home after the initial fixed-rate period ends.

The Federal Reserve has indicated that it plans to raise rates in the near future. A staff presentation recently outlined several approaches to raising short-term interest rates "when it becomes appropriate to do so," according to the April minutes of the Federal Open Market Committee.

This announcement means it's less likely that interest rates will go lower in the future, making a fixed-rate mortgage more attractive for homebuyers who plan to stay in their home for the long term.

"The consensus of most economists is that rates will be increasing in the near future," Maxon said.

Before even getting an ARM, you should understand the worst-case scenario if you hold the mortgage past the initial fixed-rate period.

Some ARMs come with a prepayment penalty. This is a fee that can be charged if you sell or refinance the loan. If you plan on selling the home or refinancing within the first five years of the mortgage, you should ask the lender for a loan without this penalty.

ARMs can come with some very complicated terms and conditions, so it's important to understand all of the terminology. Here are some common terms you should know:

  • Adjustment frequency: The amount of time between interest rate adjustments.
  • Adjustment indexes: The amount of expected interest rate change.
  • Discounted initial rate: The initial interest rate period with a fixed rate.
  • Balloon payment: A large payment that can be charged at the end of a mortgage.
  • Interest-rate cap: The limit of how much your rate can rise with each adjustment.
  • Payment cap: A limit on how much your mortgage payment can change, which is usually a percentage of the loan.
  • Points: You can pay points in return for a lower interest rate. Points equal 1% of the mortgage amount.