The San Francisco publicist pretty much made up her mind to take a 30-year fixed rate loan because she couldn’t afford the payments on the 15-year loan.
She’s buying a large, one-bedroom condo overlooking the Bay. It’s the kind of place that’s huge for one person, big enough for two, and would be a bit cramped with a third. She’s single now, but hoping to find someone, settle down and raise a family within the next few years. In fact, she expects to be out of her unit and living somewhere else within five to seven years.
You plan to stay only five to seven years. So, why are you getting a 30-year loan?
“Because I can’t afford the 15-year,” she repeated.
With interest rates hovering around the 8 percent range, interest in 30-year fixed rate loans remains strong despite the panoply of mortgage products lenders have created to make home-buying easier for first-time buyers. Only when interest rates rise toward 9 percent does the percentage of ARMs closed in a given year go up as well.
When interest rates started sinking again, into 8 and 7 percent interest rate territory, home buyers move back to fixed-rate loans in droves.
There’s nothing wrong with getting a long-term, fixed rate loan if you plan to stay in your home for an extended period of time, say, more than 7 to 10 years. The family that has already traded up two or three times, and is in a school district and home they like, has young children and is trying to plan ahead for their college tuitions are exactly the folks who should be considering a 30-year fixed rate loan.
(In fact, if they can afford it, they should try to get a 15-year loan so that they will be done paying for their home when their kids go off to college. If they can’t meet the steeper payments for a 15-year loan, they should try to pay a little extra each month and direct the lender to apply it directly to the principal. That way, they can save thousands of dollars in interest, which can be better applied toward college tuition.)
But if you’re only going to stay in your home for 5 or 7 years, or even 10 years, it doesn’t necessarily make sense to lock in on a long-term loan, mortgage experts say. There are other options out there that will save you money and for the short term are every bit as stable as a fixed-rate loan.
For example, if you’re going to stay in your home for 5 to 7 years, you have a myriad of interesting ARM choices that combine the steadiness of a fixed-rate loan with some of the lower interest rate features of a 1-year ARM.
A 5/25 (“five-twenty-five”) loan and a 7/23 (“seven-twenty-three”) loan are two-step loan programs initiated by Fannie Mae to meet this hybrid need. The loan is fixed for the first five to seven years, after which it converts either into a 1-year ARM, or a fixed-rate loan with a one-time adjustment in the interest rate.
Or, you could choose a 5-year or 7-year balloon loan. While the entire principal comes due at the end of the loan term, the interest rate will be lower than on a 30-year fixed rate loan. And yet, your 7-year balloon is amortized as if it were a 30-year fixed rate loan. Each payment is fixed for the first seven years.
Another option is a 3-year ARM, in which the mortgage adjusts every three years. Like the 5/25 and 7/23, the 3-year ARM usually has a rate cap for the adjustment year (that is, the loan can only adjust up so many points each year), which somewhat protects the home buyer from a tremendous overnight increase. Typically, ARMs can adjust upward one or two percentage points per year, but may not increase more than 5 or 6 percentage points during the life of the loan. So if your starting interest rate is 6 percent, and the loan has a 5-point cap, the interest rate on this loan will never be more than 11 percent.
For those homeowners who plan to stay in their homes for up to 10 years, your options become a little more limited. You could go with Fannie Mae’s 10/1, which is fixed for the first 10 years of the loan and then converts into a 1-year ARM. Or, you could go back to the standard 30-year fixed rate loan.
All of these ARMs carry interest rates that will be, to a greater or lesser extent, less than a 30-year fixed rate loan. And all of them carry interest rate caps that both limit the amount the rate can go up each year and the amount the interest rate can rise over the life of the loan.
Of course, every home buyer’s fear is that they’ll end up staying in their home longer than they anticipated. Many buyers worry that they’ll end up getting stuck for a heck of a lot of interest if their ARM adjusts up.
That could happen, though historically, homeowners who had ARMs saved a lot more money over the long run, as the interest rate moves down as well as up.
Or, you could simply do what Ron did. Every year for the six years he owned his vacation home in Michigan, he refinanced his he refinanced his home loan with a new 1-year ARM. In this era of no-point, no-fee loans, he has maintained an annual interest rate if no more than 6.25 percent over each of the last 5 years.
Just make sure the loan you sign doesn’t carry a prepayment penalty requiring you to cough up a large chunk of money if you refinance within the first three years of the loan.