Adjustable Rate Mortgage: What Happens When Interest Rates Go Up

Adjustable rate mortgages (ARMs) can save borrowers a lot of money in interest rates over the short to medium term. But if you are holding one when it’s time for the interest rate to reset, you may face a much higher monthly mortgage bill. That’s fine if you can afford it, but if you are like the vast majority of Americans, an increase in the amount you pay each month is likely to be hard to swallow.

Consider this: The resetting of adjustable rate mortgages during the financial crisis explains why, in part, so many people were forced into foreclosure or had to sell their home in short sales. After the housing meltdown, many financial planners placed adjustable rate mortgages in the risky category. While the ARM has gotten a bum rap, it’s not a bad mortgage product, provided borrowers know what they are getting into and what happens when an adjustable rate mortgage resets.

Interest Rate Changes with an ARM

In order to get a grasp on what is in store for you with an adjustable rate mortgage, you first have to understand how the product works. (See also: Mortgages: Fixed Rate vs. Adjustable Rate.) With an ARM, borrowers lock in an interest rate, usually a low one, for a set period of time. When that time frame ends, the mortgage interest rate resets to whatever the prevailing interest rate is. The initial period in which the rate doesn't change ranges anywhere from six months to ten years, according to the Federal Home Loan Mortgage Corporation, or Freddie Mac. For some ARM products, the interest rate a borrower pays (and the amount of the monthly payment) can increase substantially later on in the loan.

Because of the initial low interest rate it can be attractive to borrowers, particularly those who don’t plan to stay in their homes for too long or who are knowledgeable enough to refinance if interest rates go up. In recent years, with interest rates hovering at record lows, borrowers who had an adjustable rate mortgage reset or adjusted didn’t see too big a jump in their monthly payments. But that could change depending on how much and how quickly the Federal Reserve raises its benchmark rate.

Know Your Adjustment Period

In order to determine whether an ARM is a good fit, borrowers have to understand some basics about these loans. In essence the adjustment period is the period between interest rate changes. Take, for instance, an adjustable rate mortgage that has an adjustment period of one year. The mortgage product would be called a 1-year ARM, and the interest rate – and thus the monthly mortgage payment – would change once every year. If the adjustment period is three years, it is called a 3-year ARM, and the rate would change every three years. There are also some hybrid products like the 5/1 year ARM, which gives you a fixed rate for the first five years, after which the interest rate adjusts once every year.

Understand the Basis for the Rate Change

In addition to knowing how often your ARM will adjust, borrowers have to understand the basis for the change in the interest rate. Lenders base ARM rates on various indexes, with the most common being the one-year constant-maturity Treasury securities, the Cost of Funds Index and the London Interbank Offered Rate, or LIBOR. Before taking out an ARM, make sure to ask the lender which index will be used and examine how it has fluctuated in the past.

Avoid Payment Shock

One of the biggest risks ARM borrowers face when their loan adjusts is payment shock when the monthly mortgage payment rises substantially because of the rate adjustment. This can cause hardship on the borrower's part if he or she can’t afford to make the new payment.

To prevent sticker shock from happening to you, be sure to stay on top of interest rates as your adjustment period approaches. According to the Consumer Finance Protection Board, mortgage servicers are required to send you an estimate of your new payment. If the ARM is resetting for the first time, that estimate should be sent to you seven to eight months before the adjustment. If the loan has adjusted before, you’ll be notified two to four months ahead of time.

What’s more, with the first notification lenders must provide options that you can explore if you can’t afford the new rate, as well as information about how to contact a HUD-approved housing counselor. Knowing ahead of time what the new payment is going to be will give you time to budget for it, shop around for a better loan or get help figuring out what your options are.

The Bottom Line

Taking on an adjustable rate mortgage doesn’t have to be a risky endeavor, as long as you understand what happens when your mortgage interest rate resets. Unlike fixed mortgages where you pay the same interest rate over the life of the loan, with an ARM the interest rate will change after a period of time, and in some cases it may rise significantly. Knowing ahead of time how much more you’ll owe – or may owe – each month can prevent sticker shock. More important, it can help insure that you make your mortgage payment each month.

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