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At the time you purchased your home, you likely reviewed all the mortgage alternatives available to you. If you choose the mortgage that allowed for a lower monthly payment, you probably did not choose a fixed rate mortgage. An adjustable rate mortgage or an interest-only mortgage would have resulted in a lower monthly payment. Unfortunately, an increase in the general interest rates will usually cause the rates on variable mortgages to increase at the time of the schedule adjustment.
Adjustable Rate Mortgages (ARM)
There are several types of ARMs. The interest rate on the mortgage may "adjust" as frequently as every six months or may remain fixed for as long as five years, then change based on a predefined interest rate measure every year. Most ARMs place a cap or maximum on the allowable interest rate increase of each adjustment. This is usually 2%, but can vary based on the mortgage loan program.
Interest-only Mortgages (IOM)
An IOM requires the payment of interest on the outstanding mortgage balance, but no principal repayment. This type of loan will yield the lowest monthly payment. The interest rate will adjust periodically and at some point, you are required to begin to repay principal.
Enabled Higher Purchase Price
The borrower, who is focused on the ability to cash flow the monthly mortgage payment, can purchase a more expensive house by using a variable rate mortgage instead of a fixed rate mortgage. While this is appealing at the time, it may cause for financial hardship in the future if rising interest rates cause the monthly payment to increase.
The appropriate use of the adjustable rate mortgage (ARM) or interest-only mortgage (IOM) is the situation where the buyer does not anticipate owning the home for a significant number of years. For example, if the home owner anticipates being transferred to a new location by his employer within three years, then the 3/1 ARM (fixed rate for three years, then interest rate adjusts each year) would be appropriate. Likewise, if a family anticipates moving to a larger home within five years, the 5/1 ARM can be appropriate.
The IOM is appropriate if the buyer feels confident that the home will appreciate in value or at least there is no fear of the home losing market value. The appreciation will be the only build-up of equity that the owner will have since no principal is being paid down on the loan.
Hazards of Increasing Interest Rates
If the interest rate is increased on any variable loan product, the monthly payment will increase. If cash flow is sufficient to pay the higher amount, then the mortgage can be sustained. If cash flow is not sufficient to meet the higher mortgage payment along with other living expense, the borrower will be required to reduce other discretionary spending. If the borrower is not able to reduce spending, then generally other debt is created, most likely on credit cards. Without a significant increase in cash flow, the continued funding of the monthly cash shortfall with credit cards will ultimately create a financial disaster.
What to Do Now
If you have an ARM or IOM, you should do the following:
1. Review your loan agreement and determine the timing of your next interest rate adjustment.
2. Calculate the amount of the interest rate increase based on the adjustment method outlined in the loan agreement and the prevailing interest rate.
3. Calculate the increase in your monthly payment based on the new mortgage rate.
4. Determine whether the increased mortgage payment can be paid from your current cash flow.
After going through the above four steps, if you do not anticipate being able to make the higher payment, you should consider your options now.
Determine whether refinancing now would be better than waiting for the next adjustment. If the interest rate increases, all loan types, i.e. fixed and variable, will be higher in the future. Therefore, it maybe better to lock in a fixed rate mortgage now, in advance of your current loan adjustment.
Consider selling your home and paying off the mortgage. This will require purchasing a new home with an affordable mortgage or renting for a period of time. If the value of your home is less than the mortgage or is anticipated to be so due to a market turndown, selling earlier rather than later may be to your advantage. Remember if you are in this situation, others are as well. You would be well advised to get your house sold before the market is flooded.
Summary
Choosing the correct mortgage for your situation is important. Selecting a particular type of mortgage simply to allow you to purchase a higher priced home is not sound money management. If you determine that you are in a perilous cash flow predicament, you should take action now. Waiting may jeopardize your future financial security.
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