You’ve heard of them – ARM’s or adjustable rate mortgages, and some believe they are even the cause of the most recent glut of foreclosures.

My opinion (I guess whether you want it or not) is that it’s another stupid home owner trick.

You get suckered in by the low interest rate and think to yourself that you’ll refinance before the rate starts to adjust upward in 2, 3 or 5 years. That means that the interest rate is fixed for a period of time and then adjusts after a set date any where from 6 months to 10 years for example.

What has happened is, property values decreased and when a refinance was attempted there wasn’t enough value to hold the current loan amount. Now you’re stuck with the adjustable rate which makes your payment go higher and higher.

Once that happens, foreclosure is a real possibility (if you can’t afford the payment) – and has been reality for many.
 
Adjustable Rate Mortgage Overview

Adjustable rate mortgages are unique because the interest rate on the mortgage adjusts with interest rates in the marketplace. This is important to know because mortgage payment amounts are determined (in part) by the interest rate on the loan.

As the interest rate rises, the monthly payment rises. Likewise, payments fall as interest rates fall. (ya, like that ever happens right)

The rate on your adjustable rate mortgage is determined by one of several different market index’s. Many adjustable rate mortgages are tied to the LIBOR, Prime rate, Cost of Funds Index, or other index.

Adjustable Rate Mortgage Benefits

A main reason to consider adjustable rate mortgages is that you may end up with a lower monthly payment.

The bank (usually) rewards you with a lower initial rate because you’re taking the risk that interest rates increasing in the future.  This can be a good choice if you only plan on living in the home for less than the fixed rate period. For example if you have a 5 year ARM and plan on only living there for 3 years you get the advantage of the lower rate and avoid reaching the adjustable period.

Comparing the adjustable rate with a fixed rate mortgage you’ll find that you can choose the fixed rate loan and the bank takes that risk. Consider what happens if rates rise: the bank is stuck loaning you money at a below-market rate when you have a fixed rate mortgage. On the other hand, if rates fall, you’ll simply refinance and get a better rate.  (assuming you have the value available in your home)

Pitfalls of Adjustable Rate Mortgages

While you may benefit from a lower payment, you still have the risk that rates will rise once your loan rate turns from temporarily fixed to constantly adjustable.
If that happens, your monthly payment can increase dramatically. What was once an affordable payment can become a serious burden when you have an adjustable rate mortgage. The payment can get so high that you have to default on the debt.  Hence, the current state of the market (as of Sept. 2007)

Managing Adjustable Rate Mortgages

To manage the risks, you’ll want to pick the right type of adjustable rate mortgage. The best way to manage your risk is to have a loan with restrictions and “caps”. Caps are limits on how much an adjustable rate mortgage can actually adjust.

You might have caps on the interest rate applied to your loan, or you might have a cap on the dollar amount of your monthly payment. Finally, your loan may include a guaranteed number of years that must pass before the rate starts adjusting – the first five years, for example. These restrictions remove some of the risk of adjustable rate mortgages, but they can also create some problems if you cannot refinance to a fixed rate before the adjustable begins to adjust upward.