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.

40-year mortgages
You’ll get lower monthly payments with a 40-year mortgage, but consider the drawbacks as well.

As home prices have risen in recent years, new strategies have emerged to help buyers afford a home. But one of these “new” strategies is really an old one that’s returned to favor: the 40-year mortgage. A number of lenders offer them, but are they a good deal? Let’s look at the pros and cons.

What is a 40-year mortgage?

A 40-year mortgage is a conventional mortgage, but instead of repaying the principal over the standard 15, 20 or 30 years (the amortization period), you pay it off over 40 years. In many cases, the lender simply extends the life of its 30-year fixed-rate mortgage to 40 years. Some lenders also offer a 40-year version of their adjustable-rate mortgage (ARM).

The advantage

The biggest advantage of a 40-year mortgage is that you get a lower payment. For example, the monthly payment for a 30-year, $100,000 mortgage at 6 percent would be about $599. By choosing a 40-year mortgage, you would get a slightly higher interest rate — say, 6.25 percent — but your payment would fall to $568.

That’s not a huge difference, but it could be enough to let you buy a home you couldn’t afford with a 30-year mortgage. Just a few dollars a month can be the difference between qualifying for a mortgage and not qualifying. A 40-year mortgage could also help you buy a higher-priced house for the payment you can afford, especially if mortgage rates are high. Or it could leave you more money for other expenses.

The cost

A 40-year mortgage also has some drawbacks. It carries a higher interest rate — typically, .25 to .375 percentage points above an equivalent 30-year mortgage. And since you’re making payments for 10 more years, you end up paying substantially more interest. Over 40 years, you would pay a total of $172,515 in interest on that $100,000 mortgage at 6.25 percent, compared with $115,838 for a 30-year mortgage at 6 percent. That’s a difference of $56,677.

Another drawback is the speed at which you build equity in your home. With a 40-year mortgage, you will build equity much slower than with a 30-year mortgage, which means when you sell, you’ll get back less of the money you’ve paid into the house. These mortgages might also tempt you to buy a bigger house than you can afford, so it’s wise to make sure you’re not biting off more than you can chew.

Does it work for you?

Despite its faults, a 40-year mortgage may still be a good option. If you’re at an early stage in your career, it can allow you to buy a house you might not have been able to afford otherwise. As your income grows, you can refinance to a mortgage that lets you build more equity.

Remember, few people hold a mortgage to maturity. If, like most people, you move or refinance in five to seven years, the original 40-year term has little effect. And meanwhile, you’ve had the benefit of a lower monthly payment.

A 40-year mortgage can also be advantageous for high-income earners whose mortgage interest payments may be their only major income tax deduction. Or, it might reduce the carrying costs on a rental property.

There are other types of mortgages that can reduce your payments just as much as a 40-year mortgage. One alternative is an interest-only mortgage, which can give you a lower payment but builds no equity at all. Or you can choose a hybrid or regular ARM, both of which offer a lower initial interest rate but could expose you to rising rates later on.

How to choose?

Compare your payment, the interest you’ll pay and the equity you’ll build in the time you expect to be in the house. This will give you an idea of which mortgage is best for you.

Want more information? Get a FREE LendingTree Guide to Mortgages when you request a mortgage loan through LendingTree.

Why lenders require escrow accounts
An escrow account doesn’t just protect you, the borrower. It also protects the lender’s vested interest in your property.

Think of an escrow account as a safety net for your home. It financially safeguards both you and your lender against liens and property damage.

Since most of us do not have the means to buy a home outright, we rely on lenders and mortgages to help fulfill our dreams of homeownership. In turn, lenders rely on escrow accounts to ensure property taxes are paid on time and home insurance policies are kept up to date. Without the assurances provided by an escrow account, a lender’s financial risk could increase significantly.

To fully appreciate the benefits of escrow for lenders, let’s first review what escrow is, and how it works for borrowers.

What is an escrow account?
An escrow account is an account held by a third party agent who represents both the borrower and lender. The borrower makes regular deposits into the account — usually as part of a regular mortgage payment. Then, when property taxes and insurance premiums become due, the third party agent releases the funds to cover the payments.

Rather than paying your taxes or insurance in a large lump sum, many homeowners prefer the idea of spreading their property taxes and insurance premiums evenly over 12 monthly payments. Plus, with escrow, you don’t have to remember to send your payments on time. This means there’s less risk of missed payments or lapses in your insurance coverage.

The benefits of escrow to the lender
If your down payment is less than 20 percent of the property value, your lender will likely insist that you open an escrow account at the time of your mortgage closing. Even if your down payment is greater than 20 percent, your lender may recommend or require that you have an escrow account.

The reason is simple: Escrow accounts provide lenders with added security and peace of mind that their collateral — your home — is protected in a couple of important ways:

1. Your property taxes will always be paid on time, which ensures tax authorities will have no reason to place a lien on your home or foreclose on it.

2. Your home insurance premiums will always be up to date, which means your property will be covered in the event of damage or destruction caused by a fire or natural disaster.

Lenders need these assurances just as much as homeowners.

Imagine if your property taxes fell into arrears and a lien was placed on your home. It goes without saying that it would be an unfortunate experience for you and your family. But your lender would also suffer because without the collateral of your home, it may not be able to get its money back should you default on your loan.

In another scenario, let’s say your property insurance has lapsed due to a few unpaid premiums. And then, during a storm, your house is destroyed. Just as you’re left without a home, your lender is left without any collateral, since there’s no insurance to cover the loss.

You can see why so many lenders insist their borrowers use escrow accounts.

For many new homeowners, escrow accounts are the norm. Even though the funds in escrow typically do not earn interest, the account provides a convenient, hassle-free way to ensure your taxes and premiums are always paid on time. And that can offer peace of mind to you and your lender.