Mark Landt knows he’s taking on some risk by considering an adjustable-rate mortgage to finance a home as investment property, but he’s willing to bet that he can refinance later to a lower fixed rate.
“Interest rates are a little high now, so I don’t really want to lock into a 30-year fixed-rate mortgage,” said Landt, senior commercial director for Atlantic Richfield Co. in Plano, Texas. “But long term, interest rates will probably come back down, and at that time, I will probably refinance and lock into a 30-year fixed.”
Mortgage experts said that, while the interest-rate difference today between fixed-rate mortgages and adjustable-rate mortgages — known as ARMs — isn’t wide enough to make ARMs a hands-down choice, they may be a better financing vehicle over the long term for some home buyers.
As the name implies, the interest rate on an ARM isn’t fixed, as it is on a traditional mortgage. An ARM typically will have an initial interest rate that is set for a specified period — say, three years. After that time, the rate is reviewed periodically and may be adjusted up or down.
Typically, when the interest-rate difference, or spread, between fixed-rate mortgages and adjustable-rate mortgages is 2 percentage points or more, adjustable mortgages start to become attractive, said Craig Jarrell, president of the Dallas Association of Mortgage Brokers.
“We’re headed in that direction,” said Jarrell, president of Heartland Mortgage. “When that margin spreads to about 2 percentage points is when people really get excited.”
Currently, the spread is less than a full percentage point between a 30-year fixed-rate loan and a one-year ARM, said Beverly Wallace Neason, vice president and senior loan officer at Chase Manhattan Mortgage in Dallas.
But that doesn’t mean consumers should dismiss adjustable-rate mortgages as a possible financing vehicle, mortgage experts said.
Here’s why:
The Federal Reserve Board raised interest rates one-quarter point last week, and some analysts said the Fed may follow that with more rate hikes later this year.
In that scenario, fixed-rate mortgages will become more expensive and harder to get than adjustable-rate mortgages.
Mortgage rates have hit their highest level since September 1996 amid fears that the sizzling economy may trigger inflation down the road, according to the Federal Home Loan Corp., also known as Freddie Mac.
The average interest rate on 30-year fixed-rate mortgages climbed to 8.25 percent for the week ended Jan. 28. The last time rates were higher than 8.26 percent was Sept. 13, 1996, when rates on 30-year mortgages hit 8.28 percent.
“Now that fixed-rate mortgages are well above October 1998’s 31-year lows, selecting one isn’t the no-brainer it once was,” said Keith Gumbinger, an analyst with HSH Associates in Butler, N.J., which publishes mortgage information.
What’s more, some consumers just can’t qualify for a fixed-rate mortgage, he said.
“Affordability is absolutely one of the factors that falls into that,” Gumbinger said. “It is far easier to qualify for a mortgage at 6.5 percent than it is to qualify for the same amount of money at 8.5 percent.”
Fixed-rate mortgages have higher interest rates than adjustable-rate mortgages because the lender and the investor in the mortgage are committing money for a longer period of time — for example, 30 years — and shouldering the risk that interest rates will rise during that period.
With an ARM, borrowers are assuming some of that risk.
“I accept some of the risk that rates might rise or fall in that period of time, but you have to compensate me with a lower rate,” Gumbinger said.
Many consumers fear the uncertainty of their mortgage payment with an ARM because the rate eventually adjusts, but the movements haven’t been volatile, Jarrell said.
“Don’t let the word `adjustable’ scare you,” he said. “There have not been wild gyrations. It hasn’t jumped way down and way up.”
To protect borrowers from large rate increases, ARMs have limits or “caps” on the extent to which an interest rate can change.
The most common kinds of caps limit rate changes at any one time to 2 percentage points, and a total of 6 percentage points over the life of the loan, Gumbinger said.
“If you have a one-year ARM with a 2 percent per-adjustment cap, and you’re paying 6 percent, the worst you might see next year would be 8 percent,” he said.
“A typical ARM should have no more than a 2 percentage point annual cap and no more than a 6 percentage point lifetime cap,” Jarrell said.
With the many different types of ARMs available, consumers can get the peace of mind of a fixed-mortgage payment without paying the higher cost of a traditional 30-year fixed-rate loan.
Among the most popular ARMs today are “hybrid” ARMs that have a fixed rate for a specified period, such as three, five, seven or 10 years. The loan then turns into a traditional one-year ARM, whose rate may adjust annually.
The hybrid ARM allows borrowers to choose how much fixed-rate and how much adjustable-rate mortgage they want.
“It’s much like a doctor writing out a prescription that suggests medication for a particular situation, and you wouldn’t want to prescribe more than necessary,” said Ed Bratton, regional vice president of Chase Manhattan Mortgage.
How long you plan to stay in your home is a key factor when looking at an ARM.
“The average consumer doesn’t live in a home longer than seven years,” said Jim McMahan, division vice president and senior loan officer with CTX Mortgage in Addison. “What is the lowest cost of my loan over time? I would assess how many years of this 30-year loan would I really use.”
For example, if you plan to stay in your home for three years, the term of your loan should match that period, so you’re only paying for the benefit you will get during that period.
“If you believe that three years from now, your kids will be off to college and you will have different needs, there are an awful lot of incentives to benefit by taking the lower rate associated with the shorter term,” Bratton said.
“Why pay for a 30-year fixed-rate mortgage before you move up, move out and leave town?”
If you live in a house for 30 years and make the total 360 monthly mortgage payments, you will on average pay three times your loan amount, Jarrell said.
“Paying anything for 30 years is going to cost you a lot of money,” he said. “You’re paying interest for 30 years.”
Gumbinger used an example to illustrate how using an ARM instead of a traditional 30-year fixed-rate mortgage would save you money:
After a year with a $100,000 fixed-rate mortgage at 8 percent, you’ll have paid $7,970 in interest and will still owe $99,165 in principal.
But after the first year with a one-year ARM at 6.25 percent, you’ll pay only $6,217 in interest and owe $98,828 in principal.
The lower rate would enable you to pay down the principal at a faster rate, saving you interest.
Before deciding on an ARM, determine how much risk you’re willing to tolerate.
“You’re at risk because you don’t know what interest rates are going to be, and to some extent, it’s like what your investment tolerance is,” said Landt, the Arco international manager. “Inflation is really your issue.”
Consumers really need to be financially prepared for the uncertainty of an ARM, said Dallas lawyer John Schorsch, who has used adjustable-rate mortgages to finance the purchases of his homes.
“What are your cash-flow expectations in the future if the thing gets into the adjustment period?” he said. “You have to sit down and make a checklist of what your needs and your expectations are.”
Consumers should also shop around among lenders and “don’t lock in until you have to,” Landt said.
Find a good lender by getting references from friends, family and others.
“Know your lender,” Schorsch said. “It will be the biggest loan most people will take out in their lives.”
