Question: We are planning to refinance our home and are having a difficult time trying to decide whether we should go with a standard 30-year, fixed-rate loan or take a chance on an adjustable rate mortgage. We have a high school-age daughter who will be going off to college in four years. After she leaves, we’ll probably sell the house, because it’s just too big for two people. Any suggestions on how to decide between a fixed or variable-rate loan?
N.J., Redmond
Answer:Most homeowners instinctively want to refinance with a 30-year, fixed rate loan to lock in today’s low interest rates. That’s the safest, most conservative choice among the options facing the borrower in today’s mortgage market. But it’s also the most expensive.
The longer the loan term, the higher the interest rate.
Thirty-year, fixed-rate loans have the highest interest rates of any loan product on the market. The interest rate on a 15-year fixed loan is typically about half a percentage point below that of a 30-year fixed loan.
Now, in a normal mortgage market, the interest rate on a 15-year, fixed rate loan would be about a quarter percentage point higher than a five-year adjustable-rate mortgage. An ARM has an interest rate that is fixed for the first five years, and then adjusts annually for the remainder of the 30-year loan term.
But this is not a normal market.
We have a situation that financial investors call an inverted yield curve, in which short-term interest rates are higher than long-term interest rates. That’s because the Federal Reserve has been raising interest rates almost every month since June 2004.
At that time, the interest rate for a one-year Treasury bill – which is the index used to set interest rates for most ARMs – was 1percent. Today, the one-year T-bill rate is 4.5 percent. That’s a 350 percent increase in only a year and a half!
The net result is that interest rates for ARMs – which are typically significantly lower than fixed mortgage interest rates – are now almost equal to and in some cases even higher than the rates for fixed mortgages.
If this were a normal mortgage market, I would advise you to get a five-year ARM, because you would get a much lower interest rate than you could get on a 30-year, fixed rate loan, and you only need the loan for five years, or less. But that’s not the case today.
Five-year ARM interest rates are only about a quarter of a percentage point lower than 30-year, fixed rate loans, and when the spread is that close, I’d opt for the security of a fixed-rate mortgage.
You would save a little money by taking the five-year ARM, but you are assuming a lot more risk. If for some reason you end up staying in your home longer than five years, you could end paying a higher interest rate down the road. That risk is probably worth taking if you are getting an interest rate that is one percentage point lower than the 30-year fixed rate, but I don’t think it’s worth it for a quarter of a percentage point.
So this is an unusual mortgage market. As long as this inverted yield curve continues – and there is no sign that it will end anytime soon – fixed-rate loans will be the financing tool of choice.
In summer 2004, ARMs were extremely popular because of the very low interest rates at that time. But many people who took out ARMs then have seen their mortgage interest rate increase to more than 7 percent.
Until the bond yield curves return to normal, I recommend playing it safe.
Mail your real estate questions to Steve Tytler, The Herald, P.O. Box 930, Everett, WA 98206. Fax questions to Tytler at 425-339-3435 or e-mail him at economy@heraldnet.com
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