Without peeking at your classmates' answers, take this very simple, one-question quiz: What kind of mortgage do you have?
Most of you probably got an A+ and a gold star for getting that question right. We'll give you a B if you can explain how your mortgage works but you can't put a name to it. However, a poll commissioned by Bankrate discovered that a pretty astonishing 34% of people don't have a clue. If you failed this little quiz, go pull out your mortgage papers and find out.
Don't worry -- this grade won't go in your permanent record. But you should worry about the potential for payment shock. That alarming term describes what happens the moment you open a letter from your lender explaining that your monthly mortgage payment is about to go way up.
That's a possibility if you have any of several types of mortgages in which the interest rate fluctuates with the market. As a quick review, here are the types of mortgages you might have:
- Fixed-rate. Just like it sounds, your interest rate never changes over the life of the mortgage. When you think about a mortgage, you probably envision a plain-vanilla, 30-year fixed-rate loan.
- Adjustable-rate. You guessed it: Your interest rate can adjust over time. Typically, you'll pay a lower teaser rate at first. Your interest rate will then reset to reflect prevailing interest rates. Although the increase is often limited by a cap, your payments can rise substantially. If you have this kind of loan, you'll want to know when and by how much your rate will change.
- Interest-only. Your early payments on this kind of loan will cover only the interest due on your mortgage (hence the name). But at some point, you'll have to start paying principal too, which can make your payments skyrocket. Also, this kind of loan doesn't help you build equity during the years you're paying only interest. Find out when those principal payments start and how big your payments will be.
- Option ARM. Unfortunately, this isn't an opportunity to get a third appendage attached to your shoulder, enabling you to talk on the phone, type, and slurp your coffee simultaneously. Instead, this mortgage gives you the choice of paying whatever you want each month, as long as you meet a certain minimum. The problem is that the minimum payment often doesn't cover your monthly interest, and so your loan balance may be growing instead of shrinking. Eventually, you'll have to start attacking the principal on your loan, and then you'll be in for some serious payment shock.
The Bankrate poll found people have been souring on adjustable-rate mortgages in their many forms. More than one-third of people with an ARM planned to refinance to a fixed-rate loan when their interest rate adjusts. It may be that some homeowners find that the unpredictability of future payments isn't worth the low payments in the early years. However, all ARMs aren't created alike, and some serve their borrowers well.
Before rushing ahead to dump your ARM, you'll want to find the answers to some specific questions: When does your loan adjust? What index does your lender tie your interest rate to, and what is the cap on the first upward adjustments? Are there annual and lifetime interest rate caps, and how do they differ? You'll also want to find out whether you'll pay a prepayment penalty for refinancing before a certain amount of time has lapsed, as well as what your refinancing fees would be and how soon you could expect to see cost savings after refinancing.