Don't Make This Mistake if You're Considering an ARM

You could really end up regretting it if things don't go as planned.

An adjustable-rate mortgage (ARM) is a type of home loan that has a fixed rate only for a limited period of time.

For example, a 5/1 ARM would guarantee that your starting interest rate stays the same just for the first five years. At the end of that period, rates would start adjusting as often as once a year. They'd move along with a financial index they are tied to, such as the prime rate.

There are different ARM periods, such as a 3/1 ARM that has a fixed rate for three years only or a 7/1 ARM that keeps the starting rate the same for seven years.

Many people consider ARMs because they tend to have starting interest rates lower than the rates available with a 30-year fixed rate loan (that's a loan with an interest rate that never changes during the payback time). The lower starting rate can make the mortgage more affordable at first, which can make it easier to qualify.

ARMs can sometimes make sense if you can qualify for a competitive mortgage rate. But it's important not to assume that you will be able to sell your home or refinance your mortgage loan at a competitive rate before your rate begins to adjust. Here's why this matters.

Make sure you can afford an adjustable rate mortgage

Let's say you decide that you want to start off with an ARM because you plan to sell your home in three years. You may be thinking, why not get the lower rate loan since you're going to move before you need to worry about it adjusting? Or you may assume you'll be able to refinance your mortgage to a fixed-rate loan at a competitive interest rate before the starting rate changes.

The only problem is, things don't always work out as planned. You might end up unable to sell your house because property values have fallen, or because you can't find anyplace else to live.

Or you may be unable to refinance at a reasonable rate. This can happen if your income or job situation has changed and you can't qualify, or because national average rates have gone up and interest costs are much higher.

If you can't sell or refinance and your rate begins adjusting, your monthly payments (and total costs) could creep up. And in some cases, they could become difficult to afford. You could actually end up risking foreclosure if that happens.

You can't afford to put your house at risk by gambling that a move or refinance loan will always be an option. So before you take out an adjustable rate mortgage, you need to know exactly how high your rate could adjust under the worst-case scenario -- and exactly what that would do to your monthly payment.

If you can afford the highest possible monthly cost of your ARM, then you may decide you're willing to take a chance on rates rising in order to get the low starting rate. But if you can't, then chances are good the ARM isn't a good choice because there'd be too great a chance you'd end up in foreclosure if moving or refinancing didn't pan out.