ARM stands for adjustable rate mortgage. As its name implies, the interest rate on your loan fluctuates with market interest rates. This means that your monthly mortgage payment also fluctuates with market interest rates, and you must have enough flexibility in your monthly budget to cover these increases.
Most people do not have this kind of flexibility in their budgets, and that alone makes ARMs risky for them. To deal with this risk, most ARMs have payment cap clauses that cap monthly payments at a certain dollar figure. The cap, while it may seem like a good thing, actually causes an even worse problem: negative amortization.
Amortization is the process by which your loan balance is reduced as you make payments. If the payments you make are not enough to cover the full amount due, which is what happens with a cap, the mortgage company applies any partial payments to the interest owed first (that is, after all, how they make money). Any unpaid interest is added to the principal balance owed, so not only is your principal amount going unpaid, but it’s actually growing. The growth of your principal balance increases the monthly payments which in turn accelerates the negative amortization. To compound the situation, many ARMS will have a payment cap, but specifically omit interest caps. This means that while your overall monthly payment doesn’t go up, your interest owed does (if the market rate is increasing), and it further accelerates negative amortization. This is a nasty, downward spiral which for most people just ends in foreclosure.
So, given how easy it is to fall into a vicious trap of increasing debt, why would anyone enter into an ARM? If interest rates are down, ARMs provide significantly lower interest rates than fixed rate mortgages because lenders typically have an interest rate threshold several points above the market rate. So, if you intend to pay the property off quickly or flip it, you can purchase it at a significant discount, increasing your equity or profit. It also makes sense to enter into an ARM if you’re in a market with declining interest rates like the one the U.S. economy was in for the last few years. Note, however, that not only are those types of markets extremely rare but they are also short-lived. Continually declining interest rates actually only lasted for about five years, whereas most mortgages last for 15 or 30 years. In other words, you can always count on your payments going up.
So, while there are times that ARMs can make sense as a financing mechanism, by and large, they can lead to serious financial trouble and should evalutated carefully.