Deciding On New Mortgage Options

Interest rates remain low by historic standards, and the spread between fixed- and adjustable-rate mortgages remains large.

But there are widespread expectations that all rates will soon increase — unless of course the current stock market troubles cause rates to drop again. The challenge to borrowers who must choose a type of mortgage in this environment is also a challenge to anyone presumptuous enough to offer them advice.

My response to that challenge has been to develop rules that indicate the circumstances under which each of the major mortgage types should be selected.

I will illustrate with a hypothetical mortgage of $405,000 on a $450,000 single-family home to a high-credit-score borrower.

The interest rates cited are for loans carrying zero or close to zero origination fees. The numbers used have been chosen to provide readers with a feel for the magnitudes involved, but the rules are not dependent on these particular numbers.

• Fixed versus adjustable rate: In general, adjustable rate mortgages are for borrowers who don’t expect to have their mortgage longer than 12 years. Beyond that, the cumulative effect of rate increases will probably outweigh the benefits of low rates in the early years. Taking an adjustable solely because of the lower initial payment is risky because of the potential for sizeable payment increases. It should be avoided _ unless the borrower has solid reasons for expecting significant increases in future income.
• 30-year fixed-rate: The interest rate on my 30-year fixed-rate mortgage on Aug. 21 was 3.625 percent and the payment was $1,847. The 30-year fixed-rate mortgage is the default choice, meaning it is the type of mortgage selected if there is no compelling reason to select another type or if the borrower doesn’t care to invest any time considering alternatives. Even if it is not the best choice, it won’t be a terrible one.
• 15-year fixed-rate: The interest rate was 2.875 percent and the payment $2,773. Comparing the 15-year option with the 30-year option, the decision process is simple and straightforward. The payment on the 15-year mortgage is 50 percent higher, but the borrower becomes debt-free in half the time. In my book, if you can afford the payment on the 15, you take it.
• Five-one adjustable-rate mortgage: The initial rate is 2.5 percent and the payment $1,600. All adjustable-rate mortgages have 30-year terms. The prefix numbers five-one used in this case, however, indicate that the initial rate holds for five years, after which it adjusts every year. The rate on the five-one thus adjusts in months 61, 73, 84 and so on.

Borrowers who know they won’t be in their house for more than five years will minimize their costs by selecting the five-one. The risk is that their tenure will turn out to be longer than five years, and interest rates will escalate. In the worst case, where the rate on the five-one increases by the maximum amount possible, the payment will increase by 24 percent to $1,983 in month 61, by another 21 percent to $2,395 in month 73, and by 9 percent to $2,608 in month 85.

Another useful measure is the total cost of the five-one over every period exceeding five years assuming the worst possible interest rate escalation, compared to that of the 30-year fixed-rate mortgage. The adjustable-rate mortgage has lower costs over five years but higher costs thereafter, which means that there must be a break-even period. It turns out to be eight years. If the borrower is out within eight years, the five-one adjustable-rate mortgage will save the borrower money relative to the 30-year fixed-rate mortgage even if interest rates explode.

The above suggests the following rule: take the five-one adjustable-rate mortgage if:

• You are 80 percent sure you won’t have the mortgage more than five years, and …
• You are 98 percent sure you won’t have the mortgage more than eight years, and …
• If necessary, you will be able to manage a 24 percent increase in payment in month 61, a 29 percent increase in month 73, and a 9 percent increase in month 84.

Rules for seven-one and 10-one ARMs were developed in the same way.

For the seven-one ARM, the initial rate is 2.625 percent and the payment $1,627.

The decision rule is that the seven-one ARM should be selected if:

• The five-one is not a good choice, and …
• You are 80 percent sure you won’t have the mortgage more than seven years, and …
• You are 98 percent sure you won’t have the mortgage more than 10 years, and …
• If necessary, you will be able to manage a 59 percent increase in payment in month 85.

For the 10-one ARM, the initial rate is 3 percent and the payment $1,707.

The rule is that the 10-one ARM should be selected if:

• The five-one and seven-one options are not good choices, and …
• You are 80 percent sure you won’t have the mortgage more than 10 years, and …
• You are 98 percent sure you won’t have the mortgage more than 12 years, and …
• If necessary, you will be able to manage a 51 percent increase in payment in month 121.

I would be delighted to hear from anyone who chooses a particular type of mortgage after reading this article.