M is for Money

There is a deadline hanging over our heads, in December 2010 the fixed rate period for our mortgage ends. At that point our mortgage becomes adjustable, the rate will change each year based on the economy and prevailing interest rates. I had hoped we would be looking for our next home around this time, our tiny starter home isn’t the one I envisioned living out my days in. But the collapse of the housing market has made that impossible, we owe more than the house is worth. Refinancing is also not an option, we are too far underwater. At best the house is worth around $250,000. Current loan balance - $320,000. So what can I, and everyone else in this situation, do to prepare for the inevitable?

Understand Your Loan Terms

It’s time to break out that paperwork and understand the beast you are dealing with. Every adjustable rate mortgage is different, the terms and rates can vary considerably from one loan to the next. Here the most important pieces of information to gather:

1) What index is the rate based on
2) What is the rate spread
3) What is the maximum amount the rate can adjust each year
4) What is the maximum rate you can be charged

Almost all ARM mortgages contain these vital pieces of information. The rate you will be charged is based on some published index rate, mine for example is based on US Treasury Bills. Then there is the rate spread, this is the additional interest that you will be charged on top of the index rate. Mine is 2.625%, so each year’s interest rate will be based on the current index rate plus 2.625%. Obviously this could lead to huge swings in payments from year to year, so most ARM have provisions limiting how much the rate can change from one year to the next. For example mine is capped at 2% up or down. That means regardless of what happens with the index rate this year, next year’s rate cannot be below 3.5% or above 7.5% (+/- 2% from the current 5.5% rate). There is also a maximum interest rate you can be charged, so even if rates run out of control the damage is limited. Mine is capped at 10.5%.

Calculate Your Expected Payments

With the information on your loan terms you can calculate how rate resets will affect your monthly payment. Look at the worst case scenario, the maximum you could be expected pay, and build a budget around that payment. Will you be able to hold on even if the worst happens? Most likely you won’t have to face that worst case scenario for a few more years, the economy is still hobbling along and governments are loathe to raise rates right now. In fact most rate resets this year will result in a lower monthly payment, not a higher one. My best advice if that happens – don’t blow the extra money. Either keep paying the old payment so the balance goes down more quickly or set it aside for a later refinance, but only if you won’t end up spending it.

An Exit Strategy

Like many people, I want out of my adjustable rate mortgage. While there is a chance that in the near future my monthly payments will go down, I know at some point further off both the interest rate and my payment will become much higher. This situation requires an exit strategy, before the house drags us under.

First, I am hoping that rates stay low through 2010. If that happens our rate should reset lower come 2011. Then, the 2% limit per year would keep the rate reasonable for 2012 as well. 2013 is the first year I expect to face a significant payment increase. I am doubtful we will be able to refinance by then though, so my plan is to save as much as possible and hope for a refi opportunity in 2014. For that to happen we will need the housing market to rebound along with stashing significant savings. It’s not a perfect plan, but it’s better than nothing.

Anyone with an ARM who hopes to keep the house will need their own exit strategy. You may be fine for the next few years, but by the middle of the decade having an ARM will become a huge liability.


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