Adjustable-rate mortgages (ARMs) give you a fixed rate for a period of time (from one month to 10 years). After that, the rate adjusts according to the ARM's underlying index plus some margin. ARMs typically carry lower introductory rates than 30-year and 15-year fixed-rate mortgages.
But some ARMs carry risks and costs that can add up quickly.
Here's when the move can be dopey:
Steer clear of "teaser" payment-option ARMs. They offer initial rates (e.g., 2 percent) that are well below the value of the ARM's underlying index. But the rate resets upward very quickly (usually within three months) and very frequently thereafter (e.g., every month), hitting you with much bigger bills than you bargained for.
While you can pay it down as if it were a 30-year or 15-year mortgage, you also may choose to pay only the interest or just the minimum due. By paying only the minimum, however, you don't even pay off the interest you owe, which increases your loan balance - a condition known as negative amortization. Negative amortization especially hurts you when home prices fall or stay flat, because not only do you have little, if any, equity in your home, you'll owe the bank more than your home is worth.
Also, forego ARMs that don't save you much money if you can qualify for a fixed-rate loan. A 10/1 ARM often has a similar -- and sometimes higher - rate than a 30-year. "When trading off the stability and security of a fixed rate, you ought to get a bonus for that," said Keith Gumbinger, vice president of mortgage information publisher HSH Associates.
But a narrow spread can occur with shorter-term ARMs. Recently, the average rate on the 30-year fixed was 6.88 percent, not much higher than the 6.57 percent on the 7/1 ARM. That translates into monthly savings of $38 on a $200,000 loan.
If rates are considerably higher in the eighth year when your ARM resets, "you may wipe out all your savings," Gumbinger said. Ditto if you decide to refinance instead, since a refi can cost you an average of $3,000. (Here's a closer look at potential refi fees.)