MONEY OBEDIENCE

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An adjustable rate mortgage (ARM) is a mortgage with an interest rate that adjusts over time. Exactly how it adjusts depends on what terms you agree to in your mortgage contract. Normally, the ARM begins with a low interest rate, and after a predetermined length of time, it jumps to a new rate. This new rate is linked to the current market rate at the time of the "adjustment." For example, mortgages usually run 30 years, or less — perhaps 20 or 15 years only. An ARM may be based on a low interest rate during the first three years, and then jumps to a higher rate until the next adjustment date when the rate will change again. The monthly mortgage payments change with the interest rates.

You "win" if the market interest rate falls between the time you assume the mortgage and the time the interest rate adjusts. This is because your monthly mortgage payments drop when the interest rate on your mortgage goes down. Conversely, you "lose" if market interest rates go up in the same time period, because your monthly mortgage payments will also go up. In this case, it will cost you more money to keep the property. However, none of this affects you, if you sell the property before the interest rate adjusts.

With an ARM you will make different payments when interest rates adjust, as long as this new interest rate is different from the previous one. This is almost always the case. If interest rates go up, your payments will also go up. If they go down, you will make lower payments. This means that you assume the risk of fluctuating interest rates, which may become a problem if interest rates reset a much higher rate.

Let's look at an example. You take out a $200,000 adjustable rate mortgage for 30 years. At first, you pay 5% interest, which will adjust in three years to 7%. Your monthly mortgage payments for the first 3 years are approx. $1,060. After three years you will pay more than $1,280, which is an additional $220 each month. If you sell your house, you would use the proceeds of your sale to pay off the adjustable rate mortgage. Or, you can refinance, in which case you would pay off the old mortgage with the new one. Therefore, an adverse ARM scenario may never actually play out, but I think it is important to be aware of the type of risk you face with an ARM.