ARM, or adjustable rate mortgages, have an interest rate that resets once a year based on the current, prevailing interest rates. When short-term rates are significantly lower than long-term rates, ARM mortgages will have lower payments than fixed rate mortgages. Homeowners who did not understand how their ARM works can get an unpleasant surprise when it "adjusts."
Payments Can Rise
Adjustable rate mortgages will have the mortgage interest rate recalculated each year based on the current interest rates. Current rates are represented by the one-year Treasury rate, London Interbank Rate (LIBOR) or the 11th District Cost of Funds, all indicators of short-term interest rates. As the rate changes, the monthly payments of an ARM are adjusted. Lower interest rates will result in a lower monthly payment, but if interest rates rise, the payment will also increase. Many homeowners do not keep a close eye on the market rates that are the basis for their ARM rate, so they are surprised when the higher mortgage bill arrives. The amount of the increase can range from an unpleasant surprise to a payment that busts the budget.
ARMs are often sold with a teaser or lower-than-market rate for the first year. The mortgage company knows the rate and payment will increase when the mortgage rate adjusts after the first year. Homebuyers considering an ARM should ask if the initial rate is a fully-indexed rate or has been lowered to make the loan more attractive. Buyers considering an ARM should always find out what the worst case is for payment increases during the early years of the mortgage.
Difficult to Understand
A fixed rate mortgage has the same payment for the life of the loan. In contrast, ARM payments can change every year and the calculation method can be complicated. The interest rates can have annual caps and lifetime caps that limit how much the paymenta can increase. There are also several different interest rate indexes that different ARMs use to calculate the new rate each year. ARMs are designed to protect the lenders more than the homeowners, so rising rates will be adjusted into the house payment as quick as possible.
Loan Balance Stays High
A couple of extra features on some ARM types make them especially dangerous. Interest-Only ARM mortgages require that the homeowner pay only the interest on the loan balance for the first several years. When principal payments do kick in, the payments increase significantly, even if interest rates stay low. An ARM with a three year interest-only period will have the payment increase in the fourth year to be able to pay of the mortgage in 27 years instead of the typical 30 years. Option ARM products give the homeowner the option to make payments that do not even cover the interest. The money that's not paid is added to the principal balance. After a few years, the option period runs out and the payments can increase dramatically when rates rise and principal is due on the new, higher balance.