Down payment: What is the purpose?
Why do lenders want a down payment when you purchase a home? It’s all about security.

It’s standard procedure to make a down payment on a home at closing, and lenders have a good reason for wanting you to make one.

Security for the lender
A down payment provides security for the lender. If you put a significant amount of your own money into a home, you are less likely to walk away and default on the loan. Lenders, understandably, want to make sure that they’ll be repaid; your down payment provides that reassurance.

Easier loan approval for you
Another reason for lenders wanting a down payment involves loan approval. Your down payment makes it easier for you to qualify, and the more money you put down, typically, the easier it is for you to be approved. Though it may be possible now to obtain a loan with no down payment whatsoever, qualifying for a loan is a lot easier if you’re able to make a down payment.

Building your equity
When you make a down payment on a home, you’re building equity (the percentage of the property you actually own). And the more you put down, the greater your equity. The more equity you have, the less you need to finance and the less overall interest you will need to pay on your loan. A down payment therefore benefits not only the lender, but you as well.

How to avoid ARM reset shock
Concerned about rising interest rates? There are a number of ways to protect yourself from rate shock when your adjustable rate mortgage resets.

Adjustable rate mortgages (ARMs) have their advantages. For one, they often have an initial interest rate that is lower than a fixed rate mortgage. But they also have a disadvantage: one day, their interest rate will change, and you may find yourself facing “ARM reset shock.”

This occurs when the initial period is up and the interest rate is adjusted, or reset, to the current rate. Your payment then changes accordingly. If interest rates have gone up during that time — or if the initial rate was an artificially low “teaser” rate — your payment may go up steeply.

This rate shock can be even greater if you have a hybrid ARM. These mortgages have a low initial rate that stays fixed for a set period — usually two to five years. During that time, it’s easy to forget about the possibility of future higher payments should interest rates rise. But they may rise significantly at the end of the fixed-rate period. And possibly continue to rise at every subsequent six- or 12-month adjustment period.

The impact can be even more pronounced in the case of an ARM that has a discounted initial rate — a rate that’s lower than it’s fully indexed rate. For example, let’s assume you take out a $200,000 mortgage with a 30-year term, an initial one-year discounted rate of 4 percent and a fully indexed rate of 6 percent. According to the Federal Reserve Board’s Consumer Handbook on Adjustable Rate Mortgages, your first year monthly payments would be $954.83. But in the second year, when the discount period ends and the rate jumps to the fully indexed 6 percent, your payments would rise to $1,192.63. And if the index rate had also risen 1 percent during that period increasing the rate to 7 percent, your monthly payments would increase to $1,320.59. That’s an increase of $365.76 a month!

You could have a different kind of reset problem if you’ve been making the lowest allowable payment on an option ARM. These payments typically don’t cover all of the interest due on the loan, so your mortgage principal may actually be increasing. When the option ARM is recalculated, or recast — usually after five years — the higher balance is calculated in. Your payments can increase sharply, especially if interest rates have also risen. And the rate cap will not apply to this calculation.

If you have an ARM, it’s important to know when your reset date will arrive. But what can you do to protect yourself from rate shock when it does? Here are a few suggestions:

• Refinance to a fixed-rate mortgage before the reset date arrives. If you’re concerned about rising interest rates, consider refinancing. While your monthly payments may increase, you will be protected from future increases. But be sure to check if your mortgage has any prepayment penalties and to consider all of the other costs involved to determine if refinancing is right for you. Also, refinancing usually only makes sense if you plan to be in your home for several more years.

• Start a savings account so you can pay off a substantial portion of your mortgage when the reset date arrives. Check whether the terms of your mortgage allow you to do this without a prepayment penalty.

• Pay more than the minimum amount if you have an option ARM. If you’ve been paying only the least amount required, start paying the fully amortized amount. This will begin to reduce your mortgage balance before the recalculation date. If that’s not feasible, switch to the interest-only option so at least your mortgage balance won’t increase any more.

• Consolidate your debt. If a higher mortgage payment is going to make it hard for you to get by, consider seeing a credit counselor. There may be ways to restructure some of your high-interest debt by consolidating it into one lower-interest loan so you can afford the higher payments on your mortgage.

• Cut other expenses. Look to where you can cut costs to save more money. Some good places to start are services such as cable, DVR, cell phone, satellite radio, broadband internet, etc.

• Rent out part of your home. If your home is large enough, and your zoning regulations allow it, consider taking in tenants to help generate some extra cash to make the new payments.

• Downsize. If none of the above options can solve your problem, you may have to consider selling your home and downsizing to a home you can more easily afford. It’s better than facing the threat of defaulting on your mortgage. And you can always move up again in a few years once you’ve built up your home equity.

For more help understanding your options if you have an adjustable rate mortgage, visit LendingTree ARM Central.

Anxious about getting a loan? Here’s help
Go slowly to establish trust and get a home loan that meets your needs.

Let’s be honest: Applying for a home loan can be one of life’s most stressful experiences, and many people, especially first-time borrowers, are anxious about taking that first step.

Being nervous isn’t unreasonable. After all, a home loan is a major financial commitment; the application and approval processes are unfamiliar and complicated, and the ranks of loan officers, like those of any profession or trade, may include some folks who don’t have your best interest in mind.

Fortunately, there are some good strategies you can use to confront whatever fears stand in the way of your goals. Here are some suggestions to help you stop being overwhelmed by the entire process and instead focus on the first steps:

Be prepared
Before you begin to study specific loan products, think through your long-term financial and homeownership goals, and get ready to present your situation and explain your needs to the loan officer. Go over your household finances and figure out how much you can afford to spend on housing. Try to make a budget that includes estimates of property taxes, homeowner insurance, utilities, homeowner association dues, and maintenance and repairs as well as a monthly mortgage payment. For help figuring out how much you can afford, try our home affordability calculator.

Ask questions
Your initial conversation with a lending professional should be more of a fact-finding mission than a commitment on your part to obtain a loan through that individual. Prepare a list of questions you want to ask and pay attention to whether the loan officer listens to your needs and replies to your questions with information that you understand and that’s helpful to you. Take notes, so you’ll be able to reassure yourself later that you understood what you learned.

Set expectations
As part of your information-gathering process, ask the loan officer what services he or she provides. Explain that you want to be educated and kept informed about the progress of your loan. If you decide to submit an application, ask the lender to walk through the application and disclosure documents with you.

Mortgages aren’t free
No one wants to be overcharged for professional services, yet loan officers need to make a living and lenders need to make a profit to stay in business. You should expect to pay reasonable and customary costs, and you should receive a government-mandated Good Faith Estimate (GFE) of those costs before your loan closes. Tell the lending professional you don’t want to encounter any surprises when you sign your loan documents. For help understanding the GFE, read The Good Faith Estimate.

Say no
Remind yourself that you can always say no and walk away if you feel uncomfortable during your initial conversation. In fact, walking away is still an option even after you’ve completed an application, though you may have to forfeit an application or appraisal fee. Making sure you feel comfortable early in the process is the best way to protect yourself from a total meltdown later on.

Consider your options
Comparing products or services is a natural part of any big buying decision. Be sure to use a trusted source, like LendingTree.com, to help you find lenders that will meet your needs. When comparing, look beyond monthly payment and consider all the terms of the loan and how it will support your future financial goals. It’s also important to factor in how comfortable you are with the level of service you feel the lender will provide.

Rely on trusted resources
While these strategies can help you overcome your fears, at some point, you’ll need to trust the professional and company you’ve selected to do a good job for you. It’s okay to proceed slowly. Be patient, gather information, make thoughtful decisions and stay focused on your long-term financial and homeownership goals.