Is an adjustable rate mortgage (ARM) right for you? Although ARMs got a bad reputation during the meltdown of the housing and financial markets, they're still out there and still make sense for some borrowers. The question is, are you one of them?

ARMs got a bad reputation because they were often misused to enable borrowers to obtain mortgages they really couldn't afford over the long haul. Some of the more exotic types, such as option ARMs and zero-interest loans, essentially depended on rising home prices to remain affordable. So many were issued that, when people began to default on these loans, they dragged down the financial markets with them.

However, ARMs are still available and still can be a useful tool for borrowers who know how to use them properly. In addition, lenders are being a lot more cautious with the ARMs they issue these days - the most volatile, risky types that proliferated during the housing boom have essentially disappeared - so you're less likely to get into trouble with one than before.

The basic concept of an ARM is fairly simple - instead of paying a single, fixed rate over the life of the loan, you pay a varying rate that fluctuates according to market conditions. This allows you to start out paying a very low rate for several years, after which it resets to a new rate based on an index tied to current conditions.

Your original rate is typically lower than what you can get on a 30-year fixed-rate loan - often about half a percent less - because the lender doesn't have to worry about what rates are going to do 10, 15 or 20 years down the road. A long-term rate has to take those potential changes into account - an ARM can start you out with a rate based on what the markets are doing right now.

Who might benefit from an ARM?

This can be a great deal if you know you're not going to be in the home for a long time. Suppose you've taken a new job that you plan to keep for about five years before moving on, or you plan on moving up to a nicer home in five to seven years. A five- or seven-year ARM is probably what you'd want in those situations, because you don't need the long-term security of a fixed-rate loan.

What you have to look out for, though, is that the rates will reset after the initial period is over. In the popular 5/1 ARM, the rate is fixed for the first five years, then resets every year after that. So if interest rates are significantly higher five years down the road, you could see your monthly payments go up sharply if you end up staying in the home longer than anticipated.

Some financially savvy people will also take out an ARM with the intention of refinancing every few years when it's due to reset. This is more common with large mortgages, where a half-percent savings on the rate can produce significant savings, that can be invested elsewhere or used to pay down the principal more quickly. When it's time for the rate to reset, they refinance to a new ARM for another five or seven years.

Things to look out for with an ARM

The downside of this is that, you could end up with a significantly higher rate when it's time to refinance. This is particularly a concern at a time like this, when fixed rates are near historic lows - they don't seem likely to go anywhere but up. Also, there's the chance you could have trouble refinancing if your property value drops and you haven't built up significant equity to offset it - this is what got many people in trouble in the current downturn.

A big thing to look out for is how the new interest rate is determined when the ARM resets. There's usually a cap on how much it can increase, but often that cap is around five percent - meaning your interest rate could more than double if you took out a loan today at 4.5 percent or below. A two percent cap is more manageable, but still can add up pretty quickly if you can't refinance for a few years.

Another thing to watch is the formula by which the new interest rate is set. Usually, interest rates reset based on the U.S. prime rate or London Interbank Offered Rate (LIBOR), plus an additional amount, called the margin. It's the margin, which can vary widely, that you need to watch. A 2 percent margin will probably still be a fairly attractive rate; a 7 percent margin could blow you right out of the water, financially speaking.

Finally, look out for clauses than mandate minimum increases in the interest rate. ARMs don't always have to reset higher - in fact, with the sharp decline in interest rates over the past year, many borrowers are actually seeing their rates reset lower than before. But if your loan requires a minimum increase, you won't get that benefit without refinancing.

Published on November 14, 2009