Last summer, most mortgage experts were predicting that 1999 would be an excellent time to finance or refinance a home. Interest rates were widely expected to drop, and stay low throughout the year.
The experts that predicted an interest rate drop probably did so when their crystal balls were in the repair shop. Interest rates have gone up a full percentage point from where they were this time last year, and appear to be ready to float higher.
That means consumers have to make some tough decisions about what kind of mortgage will get them where they need to be when it comes to financing or refinancing their loans.
According to the Mortgage Bankers Association of America (MBA), when interest rates rise, consumers tend to steer away from long-term fixed-rate loans toward shorter-term loans, or adjustable rate mortgages (ARMs). When interest rates fall, home buyers and owner jump on the 30-year bandwagon.
The shift from long-term loans to short-term loans is a savvy response to the bond market’s jitters. Consumers have learned over the past decade or so that by choosing an ARM, they can qualify for a larger loan at a lower rate and perhaps save themselves thousands of dollars.
They’ve also realized what lenders have known for awhile – you may keep your house forever (the national average is about 8 to 11 years), but you’ll probably only keep your loan for 5 years or less.
In other words, home buyers and owners have realized that they don’t need the security of a 30-year fixed rate loan if they’re going to refinance their mortgage within 5 years.
And if they don’t need that interest rate security, they don’t need to pay for it either.
Choosing an ARM may be just what your pocketbook has ordered. To choose the right type of variable rate loan, you’ll want to examine how long you plan to keep your current loan, how long you plan to stay in your house, and exactly how much risk you’re willing to take.
Knowing how long you plan to stay in your home is crucial to making the right decision about what to buy and how to finance it. For example, if you only plan to stay for 5 years, you may purchase a single-family home that requires a little fixing up around the edges to help you build in value. That way, when you sell, you’ll either break even or come out with a tidy profit.
If you’re going to stay longer than 5 years, you may do more extensive repairs and renovations. Or, you may choose to buy in a neighborhood that might not appreciate as quickly as others in the short-term, but has long-term potential.
Use this strategy when differentiating between loan programs. Here are some issues to consider:
If interest rates are higher, consider going with an adjustable rate mortgage. If you’re going to be in your home (or keep your loan) for another 5 to 7 years, consider a two-step loan, such as a 5/25 or 7/23. These loans are fixed for the first five or seven years, at which point you can either refinance them, or they will convert into either a 1-year ARM or a fixed-rate loan.
The conversion rate will probably not be that favorable, so plan to refinance before the loan converts.
If interest rates go lower, consider taking a fixed-rate loan. If you can, try to get a 15-year loan. You’ll not only save tens of thousands of dollars in interest, but you’ll get a lower interest rate than the 30-year mortgage interest rate.
If you can’t afford a 15-year mortgage, consider getting a 20 or 25-year loan. (If you make 2 extra payments per year, you’ll cut your 30-year loan to less than 15 years.)
If you don’t mind taking on some additional risk, you’ll save extra cash each month (or be able to afford a larger loan) by going with a 1-year or 3-year ARM. These loans adjust once every year, or every 3 years. They also come in 5-, 7-, and 10-year lengths. The shorter the term, the lower the interest rate. If you’re really a risk-taker, you may find a 6-month ARM that has an even lower interest rate than a 1-year adjustable.
Most ARMs have an annual and lifetime cap. That is, they can only risk a certain amount each year (usually one or two percentage points) and can only adjust a total of five to six percentage points over the life of the loan.
For example, if your starting rate is 6 percent, and there is a lifetime cap of 5 percent, your loan will never get above 11 percent. Make sure the annual and lifetime caps are in place and you understand them before you sign your loan documentation.When purchasing a home or refinancing, you may be able to choose between financing your closing costs and fees or paying for them outright.
If you’re purchasing your home, and you can afford it, you may deduct all of your mortgage interest paid plus the points paid to obtain your loan in the year of purchase. This could be a big benefit tax-wise.
If you’re refinancing, you have to deduct your points paid over the life of the loan. However, when you sell or refinance, you may deduct the remainder of your points paid to obtain the loan.
So if you get a 1-year adjustable loan and refinance two years later, you’ll be able to deduct your remaining points and fees at that time.
NEXT WEEK: Playing the home equity game as interest rates rise.
Aug. 30, 1999.