Risky Adjustable-Rate Mortgages Are Starting to Make a Big Comeback

The dramatic rise in interest rates that has occurred over the past two months has had a big impact on the mortgage-loan market. Rates on standard 30-year mortgages have gone from below 3.5 percent as recently as late April to well above 4.5 percent currently, according to Bankrate, significantly increasing the monthly payments that new homebuyers will pay and making it harder to qualify for mortgage loans.

But there's one type of mortgage loan that hasn't seen interest rates budge: adjustable-rate mortgages. They're risky, and some blame them for the last housing bubble, but you can expect to see a big rise in the use of ARMs -- at what could be the worst possible time.

The Risks and Rewards of Adjustable-Rate Mortgages

Until recently, it didn't make sense for most would-be borrowers to look seriously at ARMs. With fixed-rate mortgages available at interest rates near or in some cases below those offered for ARMs, there was no substantial reward to make up for taking on the risk of frequent changes in the interest rate you'd pay on your loan.

Now, though, ARMs are the only way you can get a mortgage with a rate below 3 percent, and that's almost certain to make homebuyers who've missed out on low fixed-rate mortgages take a second look at adjustable-rate mortgages. Indeed, even as other mortgage rates have soared, ARM rates as reported by Bankrate have held steady between 2.7 percent and 3.1 percent. As Freddie Mac Vice President and Chief Economist Frank Nothaft observed recently, "with the ongoing run up in fixed mortgage rates, adjustable-rate mortgages are becoming more popular among homeowners looking to refinance and for home purchasers." Last week, the Mortgage Bankers Association said that the share of adjustable-rate mortgage activity rose to its highest level since July 2008.

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The benefits of an adjustable-rate mortgage when fixed rates are relatively high are easy to see. With payments that are amortized over the same period as a 30-year fixed mortgage, monthly payments on ARMs can be much lower when there's a big gap in rates between fixed and adjustable mortgages. For instance, at 3 percent, your monthly payment on a $200,000 home would be $843. At 4 percent, the payment would be $955. Put another way, if your income only qualified you for a monthly payment of $843, then paying a higher rate would only allow you to take out a loan for $177,000. So having access to lower-rate ARMs will let you spend more on the house you want, which is useful especially in light of the increases in home prices over the past year.

The problem with ARMs, though, is that the interest rate is subject to change throughout the life of the loan. For the lowest-rate ARMs available, that initial low rate is locked in for only one year, with subsequent resets on an annual basis. If short-term interest rates start to follow longer-term rates higher, then your monthly payment will skyrocket. Other types of ARMs allow you to lock in the initial rate for a longer period of time, but they start with higher interest rates, too.

Be Careful With ARMs

Before you consider an adjustable-rate mortgage, you need to understand exactly what its terms mean and what effect they could have on your payments in the future. Look closely at provisions governing maximum rate increases both annually and over the life of your loan, and run the numbers to see how much your monthly payment would rise under a broad set of realistic scenarios. The short-term interest rates on which ARMs are based are still near record lows despite the run-up in other mortgage rates, but economists believe that eventually, those short-term rates will follow suit. If you don't want to make the same mistake that resulted in many borrowers losing their homes to foreclosure during the housing bust, then taking out an adjustable-rate mortgage without having the capacity to make payments in a more normal interest rate environment is a bad idea.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google+.

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