When short-term interest rates rise, homeowners with adjustable-rate mortgages (ARMs) feel the pain. Best suited to wealthy investors who want to free up cash that can be put to work earning a rate of return that is higher than the interest on the mortgage, these loans have instead been used to help less affluent homeowners purchase homes they really cannot afford. Here we explain why relying on these loans can be a serious problem and how you can avoid the risks that come with ARMs.

Quantifying the Problem
The now former chairman of the Federal Reserve, Alan Greenspan, commented in early 2005, "People are reaching to be able to pay the prices to be able to move into a home." Nowhere is the situation more apparent than in California (the state boasting some of the nation's most expensive real estate), particularly in the San Francisco Bay area, where more than 50% of the homes purchased since 2003 were bought with interest-only loans, according to LoanPerformance.

The housing boom in the
U.S. has caused prices to soar. According to data released by the Federal Housing Finance Board (FHFB), the purchase price of the average home is now $283,800. Generally speaking, most prospective homeowners can afford to mortgage a property that costs between 2 and 2.5 times their gross annual income. Following this formula, a family seeking to purchase that $283,800 home should be earning between $113,520 and $141,900 per year. In reality, the U.S. Census Bureau reports that the median household income in 2003 (the most recent year for which data is available) was $43,318.

One look at the numbers and it is instantly apparent that a household earning the median income can't afford to purchase the "average" house. To overcome this obstacle, an increasing number of homebuyers have turned to adjustable-rate mortgages. These mortgages provide initial interest rates that are lower than the rates available through fixed-rate mortgages. The low rate is guaranteed for a set period of time - often one, three, five, seven or 10 years - before it adjusts. When short-term interest rates rise, mortgage lenders will raise their rates as well to reflect their increased cost of capital. (For additional insight into how to handle your mortgage, see Paying Off Your Mortgage and American Dream Or Mortgage Nightmare?)

Why ARMs Are Risky
Homeowners who took out ARMs in order to be able to afford the maximum house on a minimum payment could be in for an unpleasant surprise. While the adjustment rates are fully disclosed prior to purchase, many buyers fail to consider the future implications. This is particularly true with interest-only mortgages. Like other ARMs, interest-only mortgages provide a set period of time in which the payment consists only of interest on the loan. The homeowners get the benefit of a low payment, but the loan's interest rate can rise in the future - and the loan's principal must be repaid too. The end result can be ugly.

For example, on a $150,000 interest-only loan (five-year ARM) at 6% interest, your payment would be $750 per month (($150,000*0.06)/12 = $750). But five years later, you would have to start repaying the principal. Even if you were lucky enough to have the same interest rate, the payment would now increase to $966.45 a month, since the term of the loan is now only 25 years.

Calculation
Here is a breakdown of the calculation, where m is the equivalent monthly compounding rate, k is the quoted interest rate on the mortgage, and X is the monthly payment:
(1+m)12 = [1+ k/2]2, so (1+m)6 = [1+ k/2]1 = 1+.06/2 = 1.03
m = 0.4938622%
We can then solve for the monthly payment X:
$150,000 = X * [1/.004938622 – 1/(0.004938622 * 1.004938622 ^ 300]. So, X = $966.45.
Note: The number of periods used in this calculation is equal to 12 months per year times 25 years in the mortgage.

Do not be scared off by the math! Most mortgage lenders provide mortgage calculators on their website. If your mortgage lender does not provide the right calculator, check out Mortgage-Calc.com to access a variety of online mortgage calculators. You can avoid these complicated calculations by simply entering the principal remaining on the mortgage, the rate of interest and the number of years remaining on the mortgage, and it will do the math for you.

Returning to our example, if the original 6% interest rate jumped just 1%, your payment would be $1,060.17. To compare, if you had taken out a traditional 30-year fixed-rate loan, the payment would have been $899.33 - and you would have built some equity over the previous five years of payments. (For more loan comparison information, see Mortgages: Fixed-Rate Vs Adjustable-Rate.)

That's not to say that ARMs, even interest-only ARMs, aren't valuable tools. If you don't plan to stay in the property for more than a few years, ARMs can help you get a nice place to live at a reasonable price. If you are affluent and investment savvy, ARMs can also be a great tool. An interest-only mortgage on a $1-million mortgage at a 6% interest rate results in a payment of $5,000 per month versus $5,995.51 for a 30-year fixed-rate mortgage
. That's nearly $1,000 per month that can be put to work elsewhere. However, while this may be a good strategy for the affluent, the average homeowner generally saves only a few hundred dollars per month and probably doesn't have the means to turn that savings into an investment return that makes the risk and lack of home equity worth the effort.

Conclusion - Avoid Trouble
In a rising interest rate environment, taking on an ARM is a questionable strategy, and taking out an interest-only ARM can be particularly dangerous. Since you don't build equity, your payment is likely to increase when you refinance. When you add in the cost of heat, water, electricity and the other expenses associated with home ownership, the costs can quickly overwhelm a modest budget. To avoid trouble, take a conservative approach.

If you don't have an ARM, don't take one in a rising interest rate environment. If you do and you don't plan to pay off the house any time soon, consider refinancing. Also, keep in mind that many lenders will grant loans for up to 40% of your gross income, but cautious borrowers should insure that the principal, interest, taxes and insurance on your home do not exceed 28% of your gross income. Whatever path you choose, do your research and plan wisely to ensure that you manage your mortgage and your mortgage doesn't manage you. After all, forewarned is forearmed.

For a one-stop shop on subprime, adjustable-rate mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.

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