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An ARM can be a huge money saver, or a time bomb. Unfortunately, there are a lot of time bombs out there.

In my previous posting, I focused on interest only mortgages and a couple of readers pointed out the risks of these mortgages – well actually, they pointed out the risks of adjustable rate mortgages, which are a different beast entirely (though they often come in the same package).

There are many variations of adjustable rate mortgages. The worst of them are those that allow for negative amortization – meaning the principal on the loan increases over time because your payments are not sufficient to cover the interest on the loan. These loans are evil and should be avoided in almost all cases (the one exception is a reverse mortgage used by some senior citizens to turn the equity of their home into income).

Adjustable rate mortgages have two separate issues that can magnify to either save you lots of money or cost you lots of money. First, they almost always start out with below market rates (either due to marketing discounts or rates bought down through points) which results in effective interest rate increases early in the life of the loan. Second, they vary with interest rates.

When are adjustable rate mortgages a wise choice?

The only ARM I’ve had was on a condo I purchased in 1985. That year conventional mortgages were over 12% – very high from a historical perspective. It was also fairly early in my career and I was still enjoying steady increases in salary (I had a real job back then). It was also a fairly slow time for real-estate – one of the periods of stable or declining prices common in the California real estate market. The combination of high interest rates, increasing income and stagnant property values is the perfect storm for getting an ARM. Over the next ten years or so, the choice turned out to be very wise. The loan was linked to T-Bills that only once during that period exceeded the rate at the start of the loan, and at one point was 4 points lower than that initial value. Most of the years I held the loan my payments actually dropped. Ultimately I paid thousands of dollars less than I would have with a conventional loan.

I honestly don’t know if I was lucky or smart at the time – but I do remember considering the risk and deciding that it was worth the chance.

Unfortunately, most people who use adjustable rate mortgages today are using them for a different reason – to purchase a more expensive home than they can really afford. All of the factors that pointed to use of ARMs in 1985 are different today.

Right now we are at a peak of housing values after a period of rapid increase (not only recent increases, but a major increase in values in the 1999-2001 period). Historically these boom periods are separated by periods of stable or declining prices – periods of a decade or more. So purchasing the most house you can afford in order to get maximum leverage is high risk choice, at least at the moment.

Despite recent rate increases, mortgage rates remain near historic lows. That means that there is a high risk that an adjustable rate mortgage will result in higher payments over time, in some cases dramatic increases.

The final factor to consider is your own income. The recent economic recovery has not resulted in widespread wage increases. With the increased levels of outsourcing and continuing shift of manufacturing to low wage countries, there is no reason to expect wages for most people to grow significantly or even necessarily to keep up with inflation.

In short, if you currently have an ARM, you may well be sitting on a time bomb. I strongly encourage you to look at the historic values for the index on which your ARM is based to get a sense of how it might move. Interest rates during the past 4 or 5 years were generally the lowest in the past 40. Betting that they will go back down is probably a long shot.

The good news is that it may not be too late for you to get out of the trap. Fixed rate loans are still relatively cheap. If your income has increased, now may be the perfect time to refinance into a fixed rate loan and protect yourself from possible rate increases.

Mortgage and interest rate statistics:

Housing booms and busts: