THE BLOG

The Adjustable Rate Mortgage: Just Say No

02/05/2013 11:51 am ET | Updated Apr 07, 2013

There's the silly, the foolish and the completely harebrained. And then there's the adjustable rate mortgage -- ARM for short.

Like unprotected sex or one more drink, it always seems like a good idea at the time. In an environment of only low and lower rates, an ARM has looked like a good idea for many years now. The typical ARM, a "5/1" in industry parlance, gives a lower "teaser" rate upfront in exchange for a rate that adjusts annually after five years.

According to Bloomberg, today's average rates for the following mortgages are as follows:

30-Year Fixed Rate: 3.61 percent
15-Year Fixed Rate: 2.93 percent
5/1 Adjustable Rate: 2.83 percent

The ARM is the lowest. In the same way that going without any insurance is "cheaper," so is an ARM. A fixed rate mortgage grants you a guaranteed low rate in exchange for paying a rate premium. An ARM allows you to forego this premium in exchange for going without fixed-rate protection. As long as rates never rise, you'll come out ahead. Many people seem all-too-willing to make that bet.

Why would so many people opt for an ARM when it's so dangerous? Most likely, they just don't understand the risks.

First, people assume they'll be able to refinance into a fixed rate mortgage when rates rise. This is like assuming you will be able to buy flood insurance as the Tsunami rolls past. It just won't work. If you wait to refinance until then, you'll only be able to refinance at the new prevailing, higher rates.

Second, many don't remember a time when rates were rising, because it hasn't happened for nearly two score years. Back in the 1980s, mortgage rates jumped as high as 18 percent. That's right. Eighteen.

Try refinancing into that.

It's doubtful we are heading back that high, and many ARMs have rate caps that prevent them from going above, say, 12 percent. But even just a doubling of most people's payments (and even over a staggered period of years as most ARMs provide) would still overwhelm most homeowners.

Another misconception is that the risk of an ARM can be handled by simply selling the home. Well, imagine trying to sell your home at the same time as all the others who have ARMs. Or picture having to unload it in a fire sale under the pressure of a rising mortgage payment. You get the idea.

The sad truth is that most people are in ARM's because they couldn't afford the house with a fixed rate mortgage in the first place.

They are unlikely to afford it once rates start rising.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation. All investment involves risk of loss. No one should invest in any financial security or take out any loan without reading the full documents and seeking professional, personalized advice, if required.