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NJ.com
Wednesday, June 23, 2004
Mortgage rates have been ticking up since March, and the trend is expected to continue if the Federal Reserve raises interest rates next week, as is widely expected.
Conventional wisdom says this is the time to lock in low rates with a 30-year fixed-rate mortgage. But conventional wisdom may be wrong -- an adjustable-rate mortgage, or ARM, may still save some borrowers thousands of dollars.
Some lenders have a strong incentive to push these adjustable loans, because they shield the companies against losses if interest rates take off. Moreover, at a time when some borrowers are getting priced out of the fixed-rate loan market, the low start rates on adjustable mortgages can keep business coming in the door.
Those incentives mean there are some good deals for borrowers, especially those who plan to sell or refinance a home within six to eight years.
The reason is simple: Start rates on many ARM loans are significantly lower than the current rates on fixed-rate mortgages. And contractual limitations on how quickly the interest rates on an ARM can adjust virtually guarantee many borrowers will enjoy lower interest rates for years.
Moreover, if interest rates rise relatively slowly -- as some experts believe they may -- the benefits of adjustable loans can prove even greater.
"I think interest rates will be higher in a year, but I don't think there is a danger of runaway rates," said Steve Foster, president of Vista Financial, a mortgage brokerage firm in North Hollywood, Calif. "Meanwhile, there's a lot of room to run with these adjustables, which allows you to save money."
ARMs are far more complicated than fixed-rate loans, though, so borrowers must pay close attention to the details, Foster said. On the bright side, the industry offers such a wide variety that savvy borrowers can match their needs to a loan that provides both monthly savings and some security.
Foster notes borrowers who don't want to bear an immediate risk of rising rates can choose "hybrid" adjustables, which offer fixed rates for the first three to 10 years. The so-called 7-1 hybrid ARM, for example, locks in an interest rate for seven years. The current rate is 5.8 percent, compared with the going rate on a 30-year fixed-rate loan of 6.4 percent, said Keith Gumbinger, vice president of HSH Associates, a Butler rate- tracking firm.
For a $300,000 loan, the monthly payment with the 7-1 loan would be $1,760.26, compared with $1,876.52 for a 30-year fixed loan. That savings of $116.26 a month would amount to $9,766 in the first seven years. If interest rates dive again during the fixed-interest period, allowing the homeowner to refinance, that savings is permanent. (That also holds true if the homeowner sells.) Otherwise, the borrower faces the prospect of higher rates when the seven years are up.
How much higher? It's impossible to predict interest rates, of course, but borrowers can figure out a worst-case scenario for an adjustable-rate loan because of so- called caps, Gumbinger said. The typical adjustable loan will have at least one restriction, and possibly several, on how high the interest rate -- or payment -- can go in any given year and during the life of the loan.
With many ARMs, including these hybrids, the caps typically restrict the interest rate from rising more than 2 percentage points in a year or by more than 6 percentage points during the life of the loan.
Translation: The worst that could happen to the borrower on this 7-1 ARM would be that the interest rate would be 7.8 percent at the first adjustment period. That would boost the monthly payment to $2,159 -- about $283 a month more than it would have been with the fixed-rate loan.
An increase of 6 percentage points, meanwhile, could boost payments to $3,039.73. But the loan could not hit those levels until the 10th year, based on the rate caps in the contract. How long would it take for the higher monthly payments to eat up the savings the borrower enjoyed during the first seven years of the loan? At 7.8 percent, it would take almost three more years.
If interest rates continued to rise, this borrower could face a second rate increase at the beginning of the loan's ninth year, to as much as 9.8 percent. However, the lifetime cap on the loan would stop the rate from going higher than 11.8 percent no matter how high interest rates rise.
Kathy Kristof writes for the Los Angeles Times. She can be reached at kathy.kristof@latimes.com.
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