The primary risk of an adjustable rate mortgage, or ARM for short, is the specter of rising interest rates. The way ARMs work is that as interest rates change, the rate you are paying on your monthly mortgage payment can also change. This fact only hurts you if interest rates rise.
However, before we can fully understand the risks of ARMs, we must understand ARMs themselves. ARMs come in many flavors, but for the most part, the two most popular ARMs are 5-year ARMs and 7-year ARMs. While there are both shorter and longer ARMs, the five and seven year variety are by far the most common and popular.
It is also important to note that all ARMs do have a fixed period, so that a 5-year ARM is fixed for the first five years and doesn’t float until after the initial five-year fixed-rate period. Likewise with 7-year ARMs, which are fixed for the first seven years before being exposed to floating rates.
In addition, the risk of most ARMs is mitigated by the fact that there are typically caps on how high your interest rate can go. These caps usually take two forms. First, a life-time cap, which means even though your interest rate can float with rising rates (following the fixed-rate period), there is usually a ceiling beyond which the rate cannot rise under any circumstance. Second, your rate can usually only be increased so many times in a given period, such as three times per year, or seven times over three years, or what not. Be sure to understand how the caps in an ARM work before you choose this route.
The attraction with ARMs is that they almost always have lower interest rates during the initial fixed rate period than do fixed rate mortgages. This is because fixed rate mortgages pretty much are only available in the 15 year or 30 year variety. Since ARMs have shorter terms for the fixed portion, they also have shorter rates, which results in lower monthly payments (again during the fixed rate period).
My general philosophy with an ARM is this: If you can afford to payoff your
mortgage in full at any point, than an ARM makes sense for you. If you cannot afford to payoff your mortgage in full at any point, then you should probably consider a fixed rate mortgage. One word of caution regarding this philosophy: some ARMs also have a prepayment penalty, usually equal to a percentage of the original loan amount, such as 1% or 2%. However, generally this prepayment penalty is only effective during the first one or two years of the loan. Since the prepayment penalty does not apply after the fixed rate portion of the ARM it shouldn’t really impact the decision in any way (but I mentioned it anyway in the spirit of full disclosure).
In determining whether or nor you can payoff your mortgage in full, keep in mind that you can payoff your mortgage by selling your house. Therefore, if you are pretty confident that you will be moving in seven years, a 7-year ARM is likely to be your cheapest alternative (likewise if you will be moving in 5 years, go for the 5-year ARM). Even in an environment of rising interest rates, locking in a rate for 30 years isn’t going to help you if you are going to have to sell your house after seven years.