Swinging At The Right Mortgage Pitch

Call it the home buyer's paradox. When prices look affordable and borrowing turns cheap, it's usually because the national mood is grim and the economy seems dead. To take advantage of the real estate market, first you have to snap out of your depression.

Summer '92 is no exception. Mortgage rates haven't looked this tempting since the Watergate years. The difference is that lenders offer a much wider variety of home loans today than they did 20 years ago. Whether you're bold or conservative, optimistic or full of election-year angst, there's probably a mortgage product for you. All you have to do is crunch lots of numbers and read lots of fine print.

By far the most popular mortgage remains the 30-year fixed-rate loan, with interest in some regions as low as 7.75%. Next come 15-year fixed-rate mortgages, which run about a quarter-point lower than for 30-year terms. Because they're paid off in half the time, such loans are increasingly attractive to young couples who would like to make the last mortgage payment before the kids go to college and among older people who want to retire free and clear.

STEEP CURVE. No matter what the term, the security of an unchanging monthly payment is an automatic draw for the majority of home buyers. "To this day, 75% to 80% of people still reach for fixed-rate mortgages," says Vice-President Paul Havemann of HSH Associates in Butler, N.J., which tracks national mortgage trends.

But while fixed-rate mortgages offer peace of mind, they don't necessarily give you the best financial deal. For one thing, the yield curve is so steep--that is, the spread between long-term and short-term interest rates is so wide--that you can get an adjustable-rate mortgage (ARM) for as little as 4.5%, almost half the rate of a 30-year fixed. Moreover, such quotes aren't artificially low. "They're not really 'teaser' rates, because the index is in the cellar along with the rates," says Havemann. That means the lender isn't just luring new customers with an interest rate that will skyrocket the second year when it catches up with its benchmark index.

Your risk with an adjustable, of course, is that the index itself will rise steadily. Fear of such a scenario is precisely what keeps the majority of home buyers away from these loans. Instead of going with your gut reaction, though, you should do the math to find out whether a fixed or floating rate is best for you. Unless you plan to stay in your home for four years or longer, the experts say, you'll often save money with a floating-rate loan--even if your rate rises the maximum every year.

For example, say you want to borrow $150,000, and you're trying to decide between a 30-year fixed-rate mortgage at 8% and a one-year ARM at 5.75%. The ARM has an annual rate cap of 2 percentage points and a lifetime cap of 6%, meaning your interest rate can't exceed 11.75% no matter what the loan's underlying index does. Your monthly payments on the fixed mortgage would be $1,100.65, and they'd never budge. With the ARM, you'd pay only $875.36 a month the first year.

FEAR CONTROL. Assuming that one economic disaster follows another, and your rate goes up the maximum 2 points every year, your monthly ARM payments would rise to $1,074.62 the second year, $1,288.73 the third, and finally max out at $1,514.11 in year four. But after three years, your total payments add up to $758.76 less than if you'd been paying 8% all along. And if rates remain stable or rise more slowly, it will take even longer for the ARM to become more expensive than the fixed loan. In some parts of the U.S., the spread between ARM rates and longer-term mortgages is so wide that it will be seven years before a fixed-rate mortgage becomes the better deal.

One way to ease the terror of annual adjustments is to shop for a longer-term ARM. The savings within a few years can still be significant, and you feel more in control. In the example above, if you picked a three-year ARM at 7.5%, you'd pay $1,048.82 a month. Total payments after three years would be $1,865.88 less than with the 8% fixed-rate mortgage. And they'd be $1,107.12 less than you'd pay with a one-year ARM, assuming the maximum annual rate rises. For first-time home buyers who plan to trade up when the economy improves, a three-year ARM makes good sense.

But there's another peril to ARMs besides the interest-rate gamble. "People don't know the right questions to ask about adjustables," says Margaret Scott, president of Mortgage Advisory Services, a broker that works with 35 lenders in the New York area. First, she says, make sure you know to which index the ARM is pegged. Many are linked to the rate on Treasury securities of the same term--that is, a one-year ARM will be based on the one-year T-bill rate, a three-year ARM on the three-year note.

Another common index is the so-called 11th District cost of funds, established by the Federal Home Loan Bank Board in the southwestern U.S., where many banks' parent or holding companies are based. The 11th District index tends to be slightly less volatile than Treasury rates, moving up more slowly when interest rates rise and dropping more slowly when they fall. Lenders look at these indices 45 days before your loan's anniversary date and set your new rate accordingly. Knowing which benchmark a bank employs has helped many a borrower correct costly mistakes.

Second, to their costs of funds lenders add a margin of 2 to 4 percentage points. The margin is where you can lose out in the long term if you're not careful, says Scott. Here's how: Bank A offers a one-year ARM at only 5% for the first year, with a three-point margin. Bank B across the street charges 5.75% for its adjustable, but at a margin of just 2.25%.

Now, both margins exceed the 2% annual adjustment cap, so initially, Bank A seems the better deal. But once the loans are fully indexed--that is, once you're paying the underlying rate plus the bank's full margin--you'll always pay three-quarters of a point more at Bank A. On the other hand, Bank A has a lower lifetime cap, because the maximum number of percentage points will be added to a lower base rate. So, as with all mortgages, how long you plan to stay in your house and whether interest rates are trending up or down should be factors in your choice.

An increasingly popular type of mortgage, the two-step, offers the stability of a fixed-rate loan at somewhat lower rates. With a so-called 5-25 mortgage, you pay about 1 point less than the going rate for 30-year loans, and the rate stays put for five years. Then it's recalculated to reflect prevailing rates for 30-year fixed-rate mortgages. A 7-23 starts out slightly more expensive, but your rate is locked in for the first 7 of its 30 years.

With two-step mortgages, "you're getting the loan at a discount, provided you move after either five or seven years," says Scott. The bank, of course, is betting you won't move. But even if you don't, you know how your new rate will be calculated, and there's only one adjustment to live through.

Since the average American moves every six years, people who choose fixed-rate mortgages over today's cheap ARMs do so mainly for psychological reasons. But the economic cycle may bear out their instincts. Over the past 10 years, it's true, adjustable-rate mortgages have saved people money. "But that's because we've had a down trend in interest rates," remarks Warren Lasko, executive vice-president of the Mortgage Bankers Assn. As soon as interest rates begin cycling up again, the long-term loan will look smarter.

If you already have a mortgage, now may also be a superb time to refinance. In that case, you need to figure out whether it's worthwhile to pay closing costs all over again. To recoup those costs, you must either cut your monthly payments radically or stay in your house long enough for smaller payment reductions to add up.

The only reason people aren't beating down bank doors to refinance now, says HSH's Havemann, is that most of them did it back in January, when mortgage rates were almost as low as they are now. "But if you missed the boat then, your ship has now come in," he says. That can be said of anybody not too seasick to look at realestate.

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