Q: We want to get preapproved for a mortgage to buy our first home, but we’re confused by all the different loan programs available. We don’t know whether we should go with a fixed-rate loan or an adjustable rate mortgage. Fixed rate loans seem safer, but ARM loans are much cheaper. Which is better? – M.N., Everett
A: First, the question of whether to go with a fixed or adjustable rate loan depends on a couple of factors: How long do you intend to keep the property? What is your personal level of risk tolerance?
In general, an ARM is a good way to go if you intend to sell the home and trade up in a few years. ARM interest rates are lower than 30-year fixed rate loans, and with the dramatic reductions in short-term rates this year by the Federal Reserve, ARMs are currently at their lowest level in decades. The lower interest rate on an ARM may make the difference between qualifying for the loan amount you want vs. accepting a smaller amount on a fixed-rate loan.
The longer you plan to hold the loan, the more sense it makes to consider a 30-year fixed loan. Note that I said “consider.” It’s not a foregone conclusion that a fixed-rate loan is a better deal over the long haul, it just eliminates the uncertainty about the amount of your mortgage payments in the future.
Today, 30-year fixed rate mortgage rates are at historic lows. Rates change daily, but you can get a 30-year fixed rate loan in the 6.0 to 6.5 percent range now, depending on whether you want to pay loan fees. Thirty-year fixed-rate mortgages have dipped to this level only two or three times in the past 40 years. That fact alone convinces most people to opt for a fixed rate, because chances are that rates will not go much lower.
Borrowers who want the low interest rate of an ARM but the stability of a fixed-rate loan can have it both ways with so-called hybrid ARM’s that are fixed for periods of three, five or seven years before becoming adjustable. The longer the initial fixed period, the higher the interest rate.
For example, ARM’s with an initial fixed period of one year or less are available with starting rates as low as 3.5 percent. ARM’s fixed for the first three years start as low as 5.0 percent, and five-year ARM’s start as low as 5.625 percent. Those rates compare to a 30-year fixed rate loan at about 6.125 percent, assuming total loan fees of approximately 2 percent of the loan amount.
You can reduce your loan fees by accepting slightly higher interest rates.
As you can see, a one-year ARM with a starting rate of 3.5 to 4.5 percent (depending on loan fees) may be very attractive if you do not intend to keep your home or first mortgage for a long time. If you decide to go with an ARM loan, you need to be aware of the interest rate that you will pay after the initial starting rate. You need to know these two numbers: the ARM’s index and its margin.
The index is a floating financial market measure. The margin is a fixed number that is added to the index to determine your interest rate. For example, an index rate of 4 percent plus a margin of 2.75 would equal an interest rate of 6.75 percent. That is the real or fully indexed rate of your loan. ARM’s traditionally start out with low teaser rates that are 1 to 3 percent below the fully indexed rate, but with today’s low interest rates that gap no longer exists.
One-year ARM’s are typically indexed to the one-year T-bill index, which is based on the average yield on one-year U.S. Treasury bills. Last week, that index was 1.99 percent, which is more than four percentage points lower than it was early last year. With a typical margin of 2.75, that means the real interest rate on an ARM today is an amazingly low 4.74 percent.
ARM interest rate increases are typically capped at 2 percent per year, so that even if rates jump dramatically next year, your interest rate would increase only 2 percent above your starting interest rate.
So even though fixed-rate loans are at historic lows right now, so are ARM rates. If you are only going to be in a home for a few years before trading up, and ARM may be a very good choice.
Correction: The 1 percent limit on tax collections imposed by Initiative 747 will apply to local as well as state taxing districts. Last week’s column incorrectly described the scope of the initiative, which was overwhelmingly approved on the November ballot.
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
Steve Tytler is a licensed real estate broker and owner of Best Mortgage, Inc. You can visit the Best Mortage Web site at www.bestmortgage.com.
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