Do You Know Your Mortgage?

Mortgages are one of the biggest purchases a person will make. They're also the most complicated. But no matter how complex a home loan can be, you need to understand how your own mortgage works-or else you could find yourself in dire financial straits.

Nine times out of ten, a mortgage will leave a person bewildered. They tend to be very difficult to understand, especially an adjustable rate mortgage (ARM) or a home equity line of credit (HELOC). If you hold either of these, failing to comprehend how they work could hurt you financially, especially as interest rates rise.

ARMs: Prepare for the worst

ARMs are a popular first mortgage for homeowners, particularly when fixed-rates are high. They offer low, teaser rates during an introductory period, which usually lasts between one to five years. When the period is over, the mortgage rate may adjust upward, based on the current market.

That low teaser rate allows people some maneuverability in terms of monthly savings, but it can pose some significant problems if a borrower has to refinance when rates are climbing. Many homeowners get caught in a financial crunch when their teaser rate expires and they're forced to refinance to a higher rate. Watch the rate environment, and make sure that there's enough padding in your monthly budget to absorb a higher mortgage payment.

HELOCs: Variable means variable

If you have a second mortgage, do you know if it's a HELOC or a home equity loan? The difference between the two is that a HELOC is a line of credit based on the collateral in your house. It has a variable rate that's generally based on the prime lending rate. The home equity loan, on the other hand, is a fixed-rate, fixed-term loan.

HELOCs are a terrific choice when interest rates are low. However, a HELOC's variable rate is based on the prime rate, and increases by the Federal Reserve can cause it to jump. In the past several years, they've more than doubled from approximately 4 percent to more than 8 percent. It's prompted many homeowners to convert their HELOCs to home equity loans. If yours has become too expensive, consider converting to a home equity loan, or rolling your second mortgage into your first with a mortgage refinance. There's also a hybrid home equity loan, which allows you to fix the rate on a balance and maintain a variable-rate line of credit.

Knowing your mortgage will help you avoid getting stuck in a tough situation. During the loan application process, be sure that your loan officer explains all the worst-case scenarios to you. Take careful notes on what you need to be aware of in terms of market conditions, and when you'll need to refinance. Become familiar with your ARM or HELOC. Otherwise, your dream home could end up feeling like a financial nightmare.