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Published: 12/29/2005

Your Low-Interest ARM Ends. So What Now?

If you got a low-interest adjustable-rate mortgage (ARM) a few years ago that is about to adjust, prepare yourself for a shock -- an unpleasant one. Your monthly mortgage payment is about to go up. How high it goes will depend partly on interest rates, partly on what you do and, more important, when you do it. But before we look at what you can do, let's look at how ARMs work and at interest rates.

With a conventional 30-year mortgage, you make the same monthly payment month-after-month, year-after-year, for 30 years. The payments do not change, no matter what interest rates do. You do the same with a 15-year loan, but, obviously, for only 15 years.

Adjustable-rate mortgages, as the name indicates, are different. Once the initial fixed-rate loan period is over -- one year, three years, five, whatever -- the rates will adjust according to your index and the lender's margin. They cannot go higher than the lender's cap, which is generally but not always two percentage points a year and six percentage points over the life of the loan. And depending upon the type of ARM you have, those rates could readjust every year thereafter until the loan is paid off.

The initial interest rate for an ARM is always lower than on a 30-year loan, and usually lower than on a 15-year. Why? It's because people cannot predict the economic future. No one really knows what the interest rate will be next week, let alone in three, five or 30 years. So there is less financial risk in a short-term loan than in a long-term one.

There are two common reasons for getting an ARM, both concerning the interest rate. People who know they are going to move in a few years want to take advantage of the lower interest rate that comes with a three- or five-year ARM. They don't care what the rate will be afterwards because they will already have moved and will be in a new mortgage.

The other reason people choose ARMs is the rate itself. They might not plan to move, but they are looking for the lowest rate they can get at the outset -- either for financial reasons or because they can qualify to buy more house with a lower rate. They know rates might change after a few years, but they hope they will stay low. After all, there have been times when ARM payments have stayed the same or even declined after the initial adjustment period. People just hope the payments don't rise too high and that their incomes will keep pace.

Now, a lot of people who took out three-year ARMs about three years ago -- many at around 3.875 percent -- are starting to see their fixed-rate period end and their rate start to adjust -- upward. Instead of 3.875 percent, if you want to take out another three-year ARM today you are looking at 5.25 percent, or 5.875 percent if you want to convert to a 30-year loan.

Let's look at that in terms of payments.

A $100,000 mortgage at 3.85 percent required a basic monthly payment of $468.81, which includes interest and principal, but not taxes, insurance or fees and assessments. Raise that rate to 5.25 percent and the basic monthly payment jumps to $552.20, an extra $83.39 a month or $1,000.68 a year. Apply that to a 30-year loan at 5.875 percent, and the basic payment is $591.54 -- $122.73 a month higher than at the 3.85 percent rate and $39.34 more than at 5.25 percent.

Few people take out mortgages for round numbers such as $100,000. Here's an easy way to figure out what yours would be. Figure out the basic payment for $100,000, and then divide it by 100. That gives you the payment per $1,000. Let's say your loan is $137,000 at 5.875 percent. That's $5.92 per thousand. For $137,000, it would be 137 times $5.92, which works out to $810.04 a month. This is only an estimate. The actual number would $810.41, but as you can see, it's pretty close.

If you have an ARM coming due, you have two choices, each requiring two more decisions. The first choice is: Will you refinance when the adjustment date arrives and hope for the best? Or, will you refinance early and get today's rate?

The second choice is deciding what sort of mortgage you will refinance into. Will you stick with an ARM and face this same decision in another three or five years? Or, will you pay a little extra and opt for the security of a fixed-rate loan so you don't have to worry about what the interest rate will be until it is time buy a new home?

Of course, you could always just keep your mortgage and accept the rate increase -- especially if you plan to get out of it before it increases next year, which it might or might not.

Before you can make your choice, you have some serious thinking to do. There are all sorts of experts giving advice. Some will tell you that the current hike in interest rates is only temporary, and that they will go back down. Others say exactly the opposite; the fact that interest rates were as low as they were was a fiscal fluke, and that they are going to go up and stay there.

The answer to the first question could solve your problem for you. How long do you plan to live in your home? If you are sure you'll be moving in a few years, then another ARM makes sense. However, what if you have no plans to move? What do you do then?

People can suggest, but only you can decide. Since you can't really be sure what the future holds for mortgage interest rates -- or for yourself, for that matter -- what can you be sure of? How comfortable or uncomfortable are you as you see your current low interest rate coming to an end? If it doesn't really bother you, then maybe you'd be comfortable taking out another ARM. If it really does bother you, however, maybe you'll feel better with a fixed-rate loan.

Don't forget that it's your home you are dealing with, and you want it to be a comfortable place to live. For some people, having an unchanging interest rate long term is more comfortable than saving a few dollars each month with a lower short-term rate. Pick what makes you most comfortable.

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