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Yes, houses can cost you an arm and a leg, but that’s not what we’re talking about here.

The key letter in ARM is “a” and it stands for adjustable. (The whole thing stands for “adjustable rate mortgage.”) Adjustable means that the mortgage payment is a moving target. Think of it as having to use your arm to throw a baseball to hit a bowling pin at a boardwalk carnival. The interest rate can be adjustable. The payment terms can be adjustable and the time to bankruptcy can also be adjustable. In times when interest rates are expected to increase, adjustable rates are typically lower than the prevailing fixed interest rates, and the opposite is true as well.

A typical ARM has a low interest rate, a guaranteed period of time for that interest rate, an index (like LIBOR) against which it is adjusted, a step up percentage (how much the interest rate will likely grow each year) and hopefully a cap (the maximum rate it can be).

Sometimes an ARM can be in the form of interest only for the first few years. There are very low payments but no principal is paid down. The buyer is making a bet that interest rates in that timeframe will be less than they are today and that the buyer’s income will go up.

An ARM at a 3.75% guaranteed interest rate for the first 5 years, a .25% step up and a 12% cap has a schedule that looks like this:

YearInterest RateMonthly PaymentAnnual Payment
1-53.75%$1,111$13,338
64.00%$1,141$13,693
156.50%$1,399$16,526
3010.00%$1,572$18,864

The reason people buy an ARM in the first place is because they are cheap, or appear cheap to the borrower. Sometimes they are actually cheap to the borrower, but more often they are not. Bank consortiums who price mortgages are usually smart about the pricing of mortgages. Yet there is always a guy who wins the lottery.

What happens if the interest rate steps up at intervals of 1% instead of .25%?

YearInterest RateMonthly PaymentAnnual Payment
1-53.75%$1,111$13,338
64.75%$1,232$14,790
1512.00%$2,146$25,753
3012.00%$2,146$25,756

Let’s compare this to a fixed rate 5.25% mortgage.

YearInterest RateMonthly PaymentAnnual Payment
1-55.25%$1,325$15,903
65.25%$1,325$15,903
155.25%$1,325$15,903
305.25%$1,325$15,903

Notice that you are making a trade-off between low interest in the early years (ARM) and certainty (Fixed) in the later years.

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