Beware Hidden Costs of 2 New Mortgage Plans

Potential home buyers who are wary of the hassles and expense of refinancing their mortgages may feel like they are in Home Loan Heaven, thanks to two recent innovations in the mortgage market.

One, the convertible adjustable-rate mortgage, has become highly popular since it became widely available last summer. This loan, which now accounts for about one in three new mortgages, allows you to convert your adjustable rate into a fixed rate at only a fraction of the cost of a normal refinancing.

Another innovation is the reduction-option loan. Introduced late last year, it allows you to reduce your original fixed rate to a lower fixed rate--again at only a fraction of the cost of a normal refinancing.

Both type of loans also can save paper work involved in appraisals and escrow while helping you avoid the nightmares that homeowners suffered when they tried to refinance their mortgages in 1986 and early 1987. Then, strong demand for refinancings resulted in delays of as long as four or five months, forcing some homeowners to watch helplessly as interest rates shot up to the point where it was no longer worthwhile to refinance.

But before running out and signing up for one of these loans, be aware that the ability to refinance cheaply with these loans will cost you in other ways. Depending on how long you plan to live in your home and where you think interest rates may be headed, you should carefully weigh these costs against getting a conventional fixed- or adjustable-rate loan.

Whether these loans are for you “is very much a function of your personal financial situation and your tolerance for risk,” says Dennis G. Campbell, senior vice president for marketing and product management at the Federal National Mortgage Assn., better known as Fannie Mae.

“We’re asking borrowers to be more sophisticated about the costs of their loans,” says Judith Naiman, director of product strategies for the Federal Home Loan Mortgage Corp., or Freddie Mac.

Take the convertible ARM. It allows you to convert your adjustable rate to a fixed rate during a specified period, usually between the second and fifth year of your repayment term. So, if you are afraid rates will soon rise sharply, you can lock in a fixed rate. Or, if you think rates will fall, you lock in the fixed rate once you think rates have bottomed.

The fee for such a conversion can run as little as $250 to $300, far less than the $1,000 to $4,000 that it costs for a normal refinancing on a $100,000 loan. The savings come because you don’t need a new appraisal, title fees and other usual costs of refinancing.

In many cases, these convertible ARMs offer the same initial interest rates and closing costs as do conventional ARMs. Convertible ARMs also usually carry such other features of conventional ARMs as interest rate caps that limit rises in the adjustable rate.

Convertible ARMs, along with conventional ARMs, are popular now because adjustable rates are on average about 7.74% versus 9.94% on fixed rates, according to Freddie Mac. About three in four major lenders offer convertibles, Freddie Mac says.

But here’s the catch: The fixed rate you get on the conversion is usually about 0.25 percentage points higher than what you would get if you refinance into a new fixed-rate mortgage. That could cost a lot if you plan to live in your home a long time.

Let’s say you wish to convert your $100,000 ARM into a fixed rate. With a conventional refinancing at today’s rates, you might get a fixed rate of 10%, which on a 30-year loan would result in a monthly payment of $878. But on a conversion, you may be forced to take a fixed rate of 10.25%, for a monthly payment of $897.

So in effect you will be paying $19 more a month for the life of the loan, to save as little as $750 on a normal refinance. A good deal if you aren’t going to live in your house long, less of a good deal if you are.

Similar mathematics can be applied to reduction-option loans.

These 30-year fixed-rate mortgages allow you to convert your initial fixed rate to a lower fixed rate, generally between the second and sixth year. However, you can do so only once, and only if prevailing fixed rates fall to more than two percentage points below your initial fixed rate sometime in that period.

The cost of this reduction option generally runs about 0.25% of the loan’s balance, plus a $100 processing fee. So for a $100,000 loan, the tab may be only $350--far less than the $1,000 to $4,000 cost of a normal refinancing and without the time and hassle.

These loans, introduced last December, are available in California from a few selected lenders, including Shearson Lehman Mortgage, an Irvine-based firm that pioneered them.

But here’s the catch. The initial fixed rate on a reduction-option loan generally runs 0.125 percentage points higher than on a conventional fixed-rate mortgage. So, instead of a 10% rate at today’s prevailing rates, you might start with 10.125%.

Little Interest

For a $100,000 30-year loan, that will boost your monthly payment by about $10. You must judge this added cost against the chances that rates will fall 2 percentage points in the reduction-option period.

Rates fell by 2 points or more in 1980, 1982 and 1985, but that was from far higher levels than today’s. With current 30-year fixed-rate mortgages in the 10% area, rates would have to fall below 8% in the next five years or so to allow you to use the reduction option. The last time fixed-rate mortgages fell below 8% was in the mid-1970s.

“It’s really a bet,” said Peter A. Kehoe, senior vice president of marketing at Metmor Financial, a mortgage banking unit of Metropolitan Life Insurance Co. “You are betting against the lender.”

Apparently, it’s a bet most borrowers are unwilling to make in the current interest rate environment, industry officials say. “At the moment, there is very little interest in these loans,” Campbell of Fannie Mae says.

Some adjustments in terms might make these loans more popular. Linda Boehm, a senior vice president at Shearson Lehman Mortgage, said the higher initial fixed rate on a reduction-option loan may vanish in a few years, which would undoubtedly make those loans more popular than conventional fixed-rate loans.

Freddie Mac also is studying allowing the reduction option to go into effect if rates drop only 1 point or 1 1/2 points instead of 2, says the agency’s Naiman. But the options are likely to cost more, in the form of a higher initial fixed rate, she notes.

Freddie Mac also is studying making the initial fixed rate on a reduction-option loan the same as on a conventional one but making the refinanced rate a bit higher than normal, Naiman says.

Reduction-option loans also could become more popular when fixed rates rise to 12% or higher, Naiman says. That would increase the odds of a 2-point drop. But the reduction option in that case could cost slightly more in the form of a higher initial fixed rate, she says.

“I would be very surprised if lenders charged the same fee at 15% as they do at 10%,” said George Francis, president of Metmor Financial and also president of the California Mortgage Bankers Assn.

The lesson? Buyer beware. In mortgages, as in other investments, there is no free lunch. Every privilege comes at a price.