Adjusting to Rising Mortgage Rates
Now a Reality for Homeowners

In a period of rising interest rates, homeowners with adjustable-rate mortgages (ARMs) can get burned with higher monthly payments.

Earlier this month, the Federal Reserve Board, which governs the nation’s monetary policy, bumped up its short-term interest rate to 2.5 percent, its sixth quarter-point increase since June.

Mortgage rates are not directly tied to the Fed’s actions. (The regulatory agency controls the interest rates charged to member banks and how much interest member banks charge each other.) ARMs, however, have an interest rate tied to one index or another, such as rates on Treasury securities or the average cost of funds index. And those indexes can move in concert with Fed actions. With most ARMs, the interest rate is fixed for one, three or five years, and monthly payment can increase or decrease each year after that.

Here’s what you should know about ARMs in a rising rate environment:

-   Time test: Figure out how long you plan to be in your home. If you know for sure you’ll be moving in three to five years, consider an ARM. But if there’s a chance you’ll be staying longer than five years, consider paying just a bit more each month for a fixed rate loan.

What if you can’t afford the house you want with a fixed rate mortgage, but can make the payments work with and ARM? You’re asking for trouble. You might be in danger of defaulting if you’re unable to refinance to a lower rate when monthly payments increase.

-   Shrinking gap: You may find there isn’t much of a difference between your payment on a fixed-rate loan and an adjustable one as the interest rate gap narrows between the two. Rates on 30-year fixed loans have dropped nearly three-quarters of a point since May, while rates on five-and seven-year adjustable loans have come up, said Bob Walters, chief economist officer Quicken Loans in Livonia, Mich.

Say you want to borrow $200,000. You’re looking at a monthly payment of $1,167.15 with a 30-year fixed rate mortgage and an interest rate of 5.75 percent, which is about the national average. Compare that to a 3/1 ARM (fixed rate for three years then adjusts every year for the remainder of the loan” at 4.75 percent. That monthly payment would be $1, 043.29. That’s a difference of $123.86.

If your ARM has an interest rate closer to that of a fixed-rate mortgage, you may want to consider refinancing.

“The worst that can happen if you get a fixed rate is that the rates drop, but then you can refinance,” said Amelia Tyagi, co-author of “All Your Worth: The Ultimate Lifetime Money Plan” (Free Press, $24.95)due out in March. But if rates rise, you’ll find your ARM payment growing.