If you’re concerned about your mortgage payment amount when the lender resets your Adjustable Rate Mortgage, there are several ways to protect yourself from payment shock. What is payment shock? Imagine waking up one day to a statement from your mortgage lender showing that your payment amount has gone up $650 and you can no longer afford the payments. For many homeowners living paycheck to paycheck this would be a financial disaster that would result in losing their homes. Here are several tips to help protect you from payment shock with your Adjustable Rate Mortgage.
When used correctly Adjustable Rate Mortgages can save you a lot of money. There are risks mainly that your lender will reset the loan and you will no longer be able to afford your payments. What happens when your introductory period ends is that the lender adjusts your interest rate to the index your loan is tied to plus margin. The margin is the markup your lender adds to make a profit. If your Adjustable Rate Mortgage started with a lower “teaser” rate, you could see your payment go up dramatically in a short period of time.
Hybrid Adjustable Rate Mortgages are especially vulnerable to payment shock because of their extended fixed rate period. This fixed introductory period can last as long as five to seven years and many homeowners forget their payments will be adjusted until the bill arrives. Some hybrids adjust every six to twelve months after the initial reset which could wreak havoc on your monthly budget. If your hybrid is due to reset you might consider refinancing before your payment goes up.
Here’s an example to illustrate how people get into trouble with the teaser mortgage rates you see advertised with Adjustable Rate Mortgages. Suppose you refinanced you mortgage using a $200,000 Adjustable Rate Mortgage for 30 years with a 4.0% teaser rate. The fully indexed rate in your loan contract is 6.0%. During the first year under the teaser rate your monthly payment would be $955. When your introductory period ends and the lender resets your mortgage to the contract rate of 6.0% your payment will jump to $1,193. This is assumes the index rate stays below the contract rate; what would happen if your index rate jumped to 7.0 percent? If the index that your mortgage is tied to rises just one percentage point your monthly payment would jump to $1,321. That’s almost $370 higher!
Beware Option Adjustable Rate Mortgages
There are a number of risks associated with the so called “payment option” mortgage if you’ve been making the minimum payment. The minimum payment amount does not cover all of the interest due for a given month; this unpaid interest is added to your loan balance. After a period of time specified in your loan contract, typically five years, or when you reach 125% of your original loan balance due to negative amortization, the lender will recast your loan. When this happens your mortgage is converted to a standard Adjustable Rate Mortgage amortized for the time remaining in your term length…your payments will go up sharply, doubly so if interest rates have risen.
If you have an Adjustable Rate Mortgage on your home it is extremely important to find out when your loan is scheduled to reset. Here are several steps you can take to protect yourself from payment shock when this reset happens:
Refinance Your Mortgage
Refinance with a fixed rate loan before your loan resets; your monthly payment amount may go up with a fixed mortgage rate; however, you will be protected from future interest rate hikes. Make sure your mortgage does not have a prepayment penalty and determine if the fees you will pay for the new loan make refinancing worthwhile. Refinancing is a good option for homeowners that plan to keep their homes for a long time.
Save for a Rainy Day
If you can make a large payment to your mortgage principal when your loan resets, this will lessen the effect of the higher mortgage rate. Make sure that your loan contract does not include a prepayment penalty that prevents your from making large principal payments.
Avoid Optional Minimum Payments
If you’ve been making the minimum payment on an option mortgage, start making a fully amortized payment. This will reduce your loan balance before the lender recasts your mortgage. If that’s not an option due to budget restraints try and make the interest only payment to prevent negative amortization on your loan.
You can learn more about your mortgage options including costly pitfalls to avoid by registering for this free Mortgage Refinancing Blueprint.
My name is Rob Regehr and I’m a personal finance writer with a chip on my shoulder for banks and brokers that take advantage of my friends and neighbors.
