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An adjustable rate mortgage is a loan that has a low interest rate for the initial period of the loan and then adjusts to a higher interest rate based on some money market index such as the one year T-bill. A margin of two to three percent is added to the index to arrive at the adjusted interest rate, which is readjusted every year. A 5/1 jumbo ARM is a loan in excess of $417,000 that retains its original interest rate for five years and then adjusts to its higher rate, which is readjusted every year thereafter.

Jumbo mortgages are common transactions in places like California and Massachusetts, where property values have driven median home prices in many areas well past the half million dollar mark. A 5/1 jumbo mortgage was a popular choice during the housing boom from 1999 through 2005, when house appreciated in value every year and appreciated in double digits some of those years. Interest rates were also low and the combination of the two changed home shopping practices substantially.

People were willing to bet that home appreciation was going to continue and that interest rates weren't going to rise substantially in the near future. The 5/1 ARM was often the loan of choice for people who wanted to buy the most expensive house possible. The thinking was that the loan could be refinanced in five years, or the property sold at a profit. While interest rates remain fairly low, the home appreciation rise has flattened and in many areas home prices are dropping. That makes a 5/1 ARM a real financial problem for many who bought homes a few years ago.

On the date this is being written - in May of 2007 - the average rate on a thirty year fixed rate jumbo loan is 6.16%. The average 5/1 jumbo ARM is priced at an interest rate of 5.87%. All jumbo loans are more expensive, due to their size and the fact that the government is neither purchasing them nor insuring them. We'll assume that this particular 5/1 jumbo loan is for $500,000. Under the terms of the ARM, the first five years would require a monthly payment of $2956. The fixed rate loan with its higher interest rate would cost $3050.

That's not much of a difference. But in year six the ARM is going to see a substantial payment increase. One popular index is the one year T-bill, which today is paying 4.9% interest. If we assume the margin to be 2.5% then the interest rate for year six of the ARM will be 7.4%. That will bump monthly payments to $3402. From there, you will see (hopefully) a slight variation from year to year. If the ARM has a maximum interest rate of, say, 12% then the most you will ever pay on a monthly basis is a little over $4,000.

That's the range of variation a 5/1 jumbo ARM can create. In a flat housing market, it is crucial that you plan for each scenario - best case to worst. If you can't handle any one of them, look for a loan with less potential for large increases - and look for a smaller house.

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