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Adjustable Rate Mortgage: What Happens When Interest Rates Go Up

Author: Matthew Jackson

Adjustable rate mortgages can save borrowers a lot of money in interest rates over the short to medium term. But if you are holding one when it's time for the interest rate to reset, you may face a much higher monthly mortgage bill. That's fine if you can afford it, but if you are like the vast majority of Americans, an increase in the amount you pay each month is going to be hard to swallow. Consider this: the resetting of adjustable rate mortgages during the financial crisis was partly the reason so many people were forced into foreclosure or to sell their home in short sales. Post the housing meltdown, a lot of financial planners place adjustable rate mortgages in the risky category. While the ARM has gotten a bum rap, it's not a bad mortgage product in and of itself, granted borrowers know what they are getting into and what happens when an adjustable rate mortgage resets.

Interest Rate Changes With an ARM

In order to get a grasp on what is in store for you with an adjustable rate mortgage or ARM, you first have to understand how the product works. (See also: Mortgages: Fixed-Rate Versus Adjustable-Rate.) With an adjustable rate mortgage, borrowers lock in an interest rate, usually a low one, for a set period of time; subsequently when that time frame is over, the mortgage interest rate resets to whatever the prevailing interest rate is. Typically adjustable rate mortgages range in lengths from one month to five years or more. For some of the ARM products, the initial rate a borrower pays and the amount of the payment can change substantially compared to what is paid later on in the loan. Because of the initial low interest rate it can be attractive to borrowers, particularly ones who don't plan to stay in their homes for too long or who are knowledgeable enough to refinance if interest rates go up. In recent years, with interest rates hovering at record lows, borrowers who had an adjustable rate mortgage reset or adjusted didn't see that big of a jump in their monthly payments. (See also: Top 6 Mortgage Mistakes.) But that could change if the Federal Reserve moves to raise rates next year.

Know Your Adjustment Period

In order to determine whether an adjustable rate mortgage or ARM is a good fit, borrowers have to understand what the adjustment period is and what it means to their particular loans. In essence the adjustment period is the period between interest rate changes. Let's say the adjustable rate mortgage has an adjustment period of one year. The mortgage product would be called a 1-year ARM, and the interest rate and thus the monthly mortgage payment would change once every year. If the adjustment period is three years then it is called a 3-year ARM, and the rate would change every three years. There are some hybrid products out there like the 5/1 year ARM, which gives you a fixed rate for the first five years and then the interest rates adjusts once a year for every year after that.

Understand the Basis for the Rate Change

In addition to knowing how often your ARM will adjust, borrowers have to understand what the basis for the change in the interest rate is. That's because lenders base ARM rates on various indexes. The most common indexes are the 1-year constant-maturity Treasury securities, the Cost of Funds Index and the London Interbank Offered Rate. Before taking out an ARM, make sure to ask the lender what index will be used and examine how it fluctuated in the past.

Avoid Payment Shock

One of the biggest risk adjustable rate mortgage borrower's face when their loan adjusts is payment shock. (See also: Make A Risk-Based Mortgage Decision.) That happens when your monthly payment rises substantially because of the rate adjustment. This can cause hardship on the part of the borrower if he or she can't make the new payment. In order to prevent sticker shock from happening to you, you need to stay on top of interest rates as your adjustment period approaches. According to the Consumer Finance Protection Board, mortgage servicers are required to send you an estimate of your new payment. If the ARM is resetting for the first time, that estimate should be sent to you seven to eight months before the adjustment. If the loan has adjusted before, you'll be notified two to four months ahead of time. What's more, with the first notification lenders must provide options you can explore if you can't afford the new rate, and information about how to contact a HUD-approved housing counselor. (See also: 9 Signs You Can't Afford Your Mortgage.) Knowing ahead of time what the new payment is going to be will give you time to budget for it, shop around for a better loan or get help figuring out what your options are. The last thing you want to do is ignore the writing on the wall and not make your monthly mortgage payments once your ARM resets.

The Bottom Line

Taking on an adjustable rate mortgage doesn't have to be a risky endeavor, as long as you understand what happens when your mortgage interest rate resets. Unlike fixed mortgages where you pay the same interest rate over the life of the loan, with an ARM the monthly payment is going to change after a period of time and in some cases very signficantly. Knowing how much more you'll owe or may owe each month ahead of time can prevent you from facing sticker shock and more importantly from making your mortgage payments each month. (See also: The Best Candidate For an Adjustable Rate Mortgage.)

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