Mortgage Rates: Fixed Or Gamble?

Who would have thought a year ago that mortgage rates would still be so low? Initial teaser rates for one-year, adjustable-rate loans have slipped from an average of 5.45% in July to 5.20% today, with some ads boasting 4.5%. And 30-year fixed rates are the lowest they've been in a decade, averaging 8.13% but hitting 7.75% in some regions. Choosing between the two types is a dilemma not only for home buyers seeking new loans but for those who leaped at "convertible" ARMs a year ago and may now switch to a low fixed rate.

If you took the adjustable-rate plunge last January, a decline in short-term rates means that last year's 5% ARMs sport a still-pleasing 5.9% today. The choice whether to convert to a fixed rate rests largely on how long you plan to stay in your home. If you're moving in the next few years, your ARM will serve you well. But if you're staying put, you can't go very wrong by locking in now.

Converting your ARM is easy. While a traditional refinancing might mean $2,500 in closing costs and weeks of hassles, switching to a fixed rate may cost as little as $250 and only take days. But the conversion rate will probably be above the going fixed rate. Today, that can mean paying 8.5% compared with the 7.75% or 8% you might get in a traditional refinancing. Some convertible ARMs offer the reverse: a lower rate, but a bigger charge to convert.

For buyers who want a new mortgage, the choice between a fixed or floating rate also depends on the time horizon. "If you look at an ARM that's 2% less than the comparable 30-year fixed, even if rates go through the roof, ARMs will cost you less over the first three to four years," says Paul Havemann, vice-president of HSH Associates, a Butler (N.J.) mortgage-tracking firm. Rates on one-year ARMs change annually and often track one-year Treasury securities. The best ARMs don't let the rate rise by more than two percentage points a year and cap the lifetime increase at six percentage points above the initial rate.

THE HORROR. A simple comparison shows the appeal of adjustable rates. Monthly payments on a $200,000 30-year mortgage at 8.00% would be $1,468; payments on a 5.25% one-year ARM would be $1,104 the first year. Say the ARM's rate went up the maximum two percentage points a year for the next three years: After three years, you would save $3,462 with the ARM. But by the end of the fourth year, when your rate would be 11.25%, you would have paid out a total of $72,679, $2,238 more than with the fixed-rate loan. Of course, if you are willing to gamble, and interest rates don't follow this worst-case scenario, you might do better with an ARM for even longer.

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