Just when I thought that most of the pain from the mortgage lending bubble of a decade ago was behind us, we arrive at a painful milestone.
Those 10 years-interest only loans from 2006 and 2007 are resetting.
Instead of being interest only, they now move to principal and interest. And the balance originally borrowed for 30 years, has to be repaid in the remaining 20 years of the loan.
Yet, many homeowners I’ve talked to are only vaguely aware that the earth under them is about to shift. Or have only a vague plan about what to do now that it has shifted.
How amortization works
Amortization is the mathematical formula that tells you how much you have to pay each month, at a given interest rate, in order to pay off a loan over a given number of years.
The standard home loan in the US is a 30 year loan. The fixed monthly payment is calculated so that by the end of thirty years, you have repaid the amount borrowed and the interest that the loan accrued over those three decades. In the early years, most of the payment goes to interest. As the principal is reduced, interest is a smaller share of each payment.
Suppose you borrow $300,000 at 5% , amortized over 30 years. The monthly payment is $1610. In the first month, $350 goes to pay off principal, and $1250 goes to interest.
By the last payment, the principal is fully repaid.
But let’s look at the same 30 year loan, assuming it was interest only for 10 years, and the entire loan is repaid in the remaining 20 years of the loan term.
In year 11, the payment moves to $1980 per month. The first payment in the amortization period is $780 is principal and $1250 is interest.
Coping with mortgage reset
In the best of all possible worlds, you saw the reset coming and have the increased cash flow available to make the larger payments of principal and interest payment. Good work.
But if the increased payment finds you still budget challenged, you’ve got a problem.
Your choices include refinancing the loan, replacing the existing loan with a new loan, with a life longer than the 20 years remaining on your current loan.
Modification of the loan with the current lender may be an option, though you usually have to show some evidence of hardship to qualify for modification. The government-regulated loan modification programs have expired.
You can use this juncture to consider selling the home, if it’s time to relocate, downsize, or escape the work involved with home ownership.
Lastly, you can look at your options to eliminate other expenses from your budget to free up cash, or other ways to increase your income with a second job or getting a housemate.
Don’t forget that Housing and Urban Development offers expert housing counselors, free of charge.