If you don’t plan on staying long in your current home, an adjustable rate mortgage might be for you. But beware its pitfalls — many people who go into foreclosure are there courtesy of an adjustable rate mortgage, as their rate increased but they didn’t have the cash flow to pay the bill. 

An Adjustable Rate Mortgage (ARM) is a common type of mortgage loan with an interest rate that will change — or “adjust” – periodically, such as every 3 years or annually after the 5th year, which alters the monthly payment that is due. This is exactly opposite of a fixed-rate loan, whose rate does not change.

The new rate for an adjustable rate loan is calculated against a current index plus a margin. For example, if the index being used is 5% and the margin is 3%, the rate on the loan will change to 8% after its prespecified adjustment date. Your mortgage documents should clearly state what your rate will be after your mortgage resets.

ARMs have rate caps that limit how much they can increase annually, or over the life of a loan. For example, if your life-of-loan cap is 5%, and your initial rate is 5%, your loan rate will never exceed 10% during the entire loan period. People who sign up for ARMs need to be careful that they understand what the home loan will adjust to, and make sure they have the cash flow to cover that future payment. Or they must have an exit plan to get out, whether that’s moving, or refinancing.

According to think tank the Center for American Progress, when ARMs adjust, they add an average of $10,000 in annual payments. 

ARMs are the best option if you plan to sell the home before the rate adjusts; otherwise a fixed-rate is best if you plan to be in a home for a while or are not sure how long it will be before you sell.

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