Most have an initial fixed-rate period during which the borrower's rate doesn't change, followed by a much longer period during which the rate changes at preset intervals.

Adjustable rates start low

The initial fixed-rate period can be as short as a month and as long as 10 years. One-year ARMs, which have their first adjustment after one year, used to be the most popular and were the benchmark. Recently the standard has become the 5/1 ARM, which has an initial fixed-rate period that lasts five years; the rate is adjusted annually thereafter. That type of mortgage, which mixes a lengthy fixed period with an even lengthier adjustable period, is known as a hybrid. Other popular hybrid ARMs are the 3/1, the 7/1 and the 10/1.

After the fixed-rate honeymoon, an ARM's rate fluctuates at the same rate as an index spelled out in closing documents. The lender finds out what the index value is, adds a margin to that figure and recalculates the borrower's new rate and payment. The process repeats each time an adjustment date rolls around.

Interest-only ARMs

Variety of flavors

To keep your financial options open, make sure to ask the mortgage lender if the ARM is convertible to a fixed-rate mortgage. Also, ask if the ARM is assumable, which means that when you sell your home the buyer may qualify to assume your existing mortgage. That could be desirable if mortgage interest rates are high.

A home equity loan or line of credit allows you to borrow money, using your home's equity as collateral.

First, some definitions:

Collateral is property that you pledge as a guarantee that you will repay a debt. If you don't repay the debt, the lender can take your collateral and sell it to get its money back. With a home equity loan or line of credit, you pledge your home as collateral. You can lose the home and be forced to move out if you don't repay the debt.

Equity is the difference between how much the home is worth and how much you owe on the mortgage (or mortgages, if you have a home equity loan or line of credit).

Example 1

Fast-forward five years. You have been making your monthly payments faithfully, and have paid down $13,000 of the mortgage debt, so you owe $167,000. During the same time, the value of the house has increased. Now it is worth $300,000. Your equity is $133,000: $300,000 (home's current appraised value) - $167,000 (amount owed) = $133,000 (equity).

In the housing meltdown that began in 2006, many homes lost equity rather than gained it. Instead of increasing, the value of the house dropped after the home was purchased. In many instances, a home equity loan would not be available.

Using the above example, let's say you buy a house for $200,000. You make a down payment of $20,000 and borrow $180,000. During the next five years, you paid down $13,000 of your mortage debt.

As home prices fell and homes in your neighborhood went into foreclosure, your home's value dropped by 30 percent, or $54,000, to $126,000. Because the value of your home is less than the amount you owe, you have $41,000 in negative equity and would not be eligible for a home equity loan.

A home equity loan (or line of credit) is a second mortgage that lets you turn equity into cash, allowing you to spend it on home improvements, debt consolidation, college education or other expenses.