Dangers of an Adjustable Rate Mortgage (ARM)

An adjustable rate mortgage (ARM) is one of many mortgage loans available.  There are several different types of ARMs available, though the most common are 1 year and 5 year ARMs.  What this means is that every year or every five years on the anniversary of the loan, the interest rate will be adjusted based on the index that the loan is linked to.  Home buyers often opt for an adjustable rate mortgage for several reasons.

Reason One:  They don’t plan to stay in the home permanently.

Reality:  People often say they only plan to stay in a home for five years or less, but then life intervenes.  They may end up staying in that house much longer, either because they are unable to sell it (as is the case for many homeowners now), or because they don’t have enough money to move to a new home, or because they find the home suits them just fine.  If a person does decide to stay in the home, they will then either have to accept the ARM adjustment when it is time or look at refinancing, which can cost several thousand dollars.

Reason Two:  They want to capture a lower interest rate than what is available for a 30 year fixed mortgage, which may offer them temporarily lower house payments overall.

Reality:  True, an ARM may initially offer you a lower interest rate, and therefore, a lower monthly payment than a 30 year fixed mortgage.  However, this thinking is often short sighted.  While you may save more in the one or five year terms of the ARM, when the rate is adjusted in a market like this where interest rates are already so low, you will usually end up paying more over the course of the 30 year loan.

Reason Three:  They think their financial situation will improve in the future and they will be able to afford a higher payment when they refinance to a 30 year fixed mortgage in a few years.

Reality:  People may often think that their income will be increasing yearly, so after five years, they will be better able to handle a larger monthly payment.  The reality is that it is dangerous to bank on your future self.  What if you are laid off or injured and are not able to work as much as you would like?  When buying a home, try to take on a fixed mortgage payment that you can afford now, usually a 30 year fixed rate mortgage.  It is much better to buy less house, have payments you can afford easily now, and then watch those payments become more and more affordable as you earn more.

While an adjustable rate mortgage does offer homebuyers flexibility, it is a risky proposition in these current economic times.  Interest rates are already very low; in the future, the only place they have to go is up, which means when it is time for the change in your ARM rates, your monthly home payment can increase by several hundred dollars per month.  Yes, you saved money in the beginning by taking out at ARM instead of a fixed rate 30 year mortgage, but over the life of the ARM, you may end up paying much more.  If there is anything the market should have taught home buyers over the last few years, it is that they should be conservative and not buy more house than they can afford in a manner that may easily put them in a financial bind a few years down the road.