Archive for Sunday, May 23, 2004

Comment: Some pros and cons of various home loans

May 23, 2004


By now, we should all have gotten the message: Interest rates are going to rise, making mortgages more expensive.

Rates are still pretty good, with the standard 30-year fixed mortgage going for around 6.5 percent, up from 5.5 percent in March. Historically, rates of 8 percent or more are typical, so I wouldn't be unhappy about locking in at today's rate.

But there are ways to get lower rates -- nearly as low as 4 percent on some deals. A variety of loans offer rates below those of the standard 30-year fixed mortgage.

In all cases, there's a tradeoff, so that each type only serves borrowers in specific situations. Here's a rundown on the current rates, and the pros and cons of each type of loan.

15-year mortgages

These now average about 6 percent, up from about 5 percent in March, according to HSH Associates, a Pompton Plains, N.J., rate-tracking firm. Thus, you can lock in that rate for the full 15-year life of the mortgage, beating the 30-year rate by a half percentage point or so.

The disadvantage is that despite the lower rates, monthly payments are higher than for 30-year loans of the same size. That's because the principal -- the amount borrowed -- has to be paid back twice as fast, boosting the principal portion of the payment.

For every $1,000 borrowed, the monthly payment on a 15-year loan at 6 percent would be $8.44, versus $6.32 on a 30-year loan at 6.5 percent.

If you can shoulder the higher payment, the 15-year mortgage will save you a bundle in interest over the life of the loan, since you pay interest only half as long.

However, you could save almost as much interest by voluntarily making extra principal payments on a 30-year loan to pay it off ahead of schedule. That way, you wouldn't be required to make the bigger payments, as you would with a 15-year loan, leaving you some breathing room on a tight month.

One-year ARMS

The one-year adjustable-rate-mortgage. These now charge an average of 4.27 percent for the first year, HSH says. They were at 3.6 percent in March.

The catch: The rate will adjust every 12 months, usually by adding 2.75 percentage points to the rate paid by one-year U.S. Treasury securities. So, when prevailing rates rise, ARM rates do, too. Usually, ARMs can go up or down no more than 2 percentage points in a year, or a total of 6 points during the life of the loan.

That means an ARM issued today could someday charge a stinging 10.27 percent.

Obviously, ARMs offer a nice savings over 30-year loans for the first 12 months. And because the first year's payments are low, borrowers can qualify for bigger loans.

But ARMs generally must offer bigger up-front savings than today's to be good long-term bets. And they're more attractive when the short-term interest rates that determine adjustments are likely to fall over coming years. Since most economists think rates will rise, one-year ARMs are not very appealing right now.

Hybrid ARMs

These offer a starting rate for three, five, seven or 10 years, then go to an annual adjustment the same as one-year ARMs. Obviously, the appeal is the longer period for the cheap up-front deal.

A hybrid might be good if you think the short-term rates used for adjustments will come back down by the time the adjustments begin.

And a hybrid might serve if you figure you'll only have the loan for a few years. In fact, savings during the initial years can be big enough to offset for several years the higher rates you might pay after the adjustments begin. If you'll have the loan only seven or eight years, a five-year hybrid might be cheaper than a 30-year loan even if the hybrid makes maximum adjustments for a year or two.

According to HSH, average rates are 4.5 percent on three-year hybrids, 5.1 percent on five-year ones, 5.5 percent for seven-years and 5.8 percent for 10 years.

That makes the three- and five-year hybrids pretty appealing. But I'd probably choose a 15-year fixed mortgage at 6 percent over the seven and 10-year hybrids.

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