How to avoid ARM rate reset shock

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.

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