Adjustable Rate Mortgage Risks Explained by Coventry Enterprises of America

Adjustable-rate mortgages were at the center of the 2008 housing crisis because millions of borrowers did not understand how the rate adjustments would work. While today's ARM products have stronger consumer protections, the fundamental risks remain. Coventry Enterprises of America explains what those risks are and how to evaluate them before choosing an ARM.

How ARM Adjustments Work

A typical ARM has three key numbers: the initial fixed period, the adjustment frequency, and the margin. A 5/1 ARM has a five-year fixed period followed by annual adjustments. The adjusted rate is calculated by adding a fixed margin to a benchmark index, usually the Secured Overnight Financing Rate (SOFR) or a similar market rate.

If the margin is 2.5 percent and the SOFR at the first adjustment date is 4.0 percent, your new rate is 6.5 percent. If rates have risen significantly by then, your rate and payment can increase substantially. This is payment shock: the sudden jump in monthly obligation that catches borrowers off guard when the adjustment period begins.

Rate Caps: Your Protection Has Limits

Modern ARMs come with caps that limit rate increases. A common cap structure is 2/2/5, meaning the rate can increase no more than 2 percentage points at the first adjustment, no more than 2 points at each subsequent adjustment, and no more than 5 points above the initial rate over the life of the loan. If your initial rate is 5.5 percent, the maximum rate is 10.5 percent.

Calculate your worst-case payment at the maximum rate before choosing an ARM. If that payment would be unaffordable, the ARM is not appropriate for your situation regardless of how attractive the initial rate is.

When ARMs Make Sense

ARMs are appropriate when you are confident you will sell or refinance before the first adjustment. If you plan to move in four years, a 5/1 ARM that is 0.75 percent below the 30-year fixed rate saves real money. The risk you are taking is that your plans change. Life does not always cooperate with financial planning.

ARMs also make sense when the spread between ARM and fixed rates is large enough to justify the risk given your specific situation. When that spread is narrow, there is little reason to accept the uncertainty of an ARM when a fixed rate is nearly as affordable.