Q We are planning to refinance our home, and we 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 five 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
A 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 myriad 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-rate loan is typically about one-half percentage point below that of a 30-year loan.
Likewise, 15-year fixed interest rates are about one-quarter percentage point higher than a five-year adjustable rate mortgage , which 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. The interest rate on a three-year ARM is about one-half percentage point lower than a five-year ARM. And so it goes.
What’s the point of all this?
Simply that you shouldn’t pay for a longer loan period than you really need. Homeowners who are living in their dream home and plan to spend the rest of their lives there should probably opt for a nice, safe 30-year fixed rate loan – unless they can afford the higher payments of a 15-year loan, with its faster payoff and lower interest rate.
On the other extreme, people who plan to sell their home in two or three years might do well with a one-year ARM (interest rate adjusts annually), which are available with first-year interest rates of 3 percent or less. The huge savings during the low initial teaser rate period of the loan would allow them to recover their closing costs in a matter of months. Even if the ARM adjusted up to 5 percent interest in the second year of the loan, they’d still have a very attractive rate. The lifetime cap rate of the loan would be 9 percent (6 percent above the starting rate), but if the house was sold in two or three years as planned, they’d never have to face the worst case rate scenario.
Interest-only loans have also become popular recently because they offer the absolute lowest possible monthly payment. The difference between an interest-only loan and a traditional amortized loan is that there is no payment to reduce the principal balance of the loan. In other words, you would owe the same amount of money at the end of the loan period as when you started. This is a good option if you want to keep your monthly payments low and keep the extra cash to invest elsewhere.
As you can see, a key factor in the refinancing equation is determining how long you plan to keep the loan. For some people that’s a very difficult question. They might say, “We really love this place and we could live here forever. But, on the other hand, we’ve been looking at some houses over in this new subdivision.”
Few of us are prescient enough to know exactly what we will be doing several years from now, but homeowners who are refinancing must choose between the safety of a 15- or 30-year fixed-rate loan (which means paying an unnecessarily high rate of interest if they sell in a few years) or taking a chance on an ARM loan (possibly ending up with a higher interest rate if they keep the home longer than originally planned). The average American family moves every five to seven years. Mortgage investors are willing to give you a break on the interest rate if they know they’re going to get their money back in only a few years. If you want a flat rate of interest for 30-years, they are going to build in extra profit to compensate for the risk that interest rates might rise during that period.
In the specific situation described in your letter, a five-year ARM might be a good choice. The interest rate is fixed for five years, which is about how long you plan to keep your home, and you’d save approximately three-quarters to one full percentage point off the interest rate you would get on a 30-year fixed-rate loan.
The only risk is that you might not sell your home in five years and your interest rate would then adjust annually, based on existing mortgage rates. Because of recent interest rate hikes by the Federal Reserve, ARM interest rates are increasing. Who knows what interest rates will be five years from now? There are protections built into the ARM loan programs. Your interest rate cannot increase more than two percentage points for any rate adjustment, and it can never be more than 6 percent higher than your starting rate.
As I said earlier, the toughest decision in selecting the best mortgage is determining how long you will own your home. If you can answer that question with some degree of certainty, it becomes a relatively simple matter of finding the shortest loan term that meets your needs. Don’t pay a 30-year rate when you really need only a five-year loan, or less.
Mail 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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