Homeowners Should Reconsider Fixed-Rate Fixation
Free-falling interest rates--now at their lowest levels in roughly 30 years--are spurring another wave of mortgage refinancing activity. Thousands of consumers are swamping the phone lines at banks, thrifts and mortgage banking concerns with questions about refinancing their home loans.
Most homeowners tend toward fixed-rate mortgages when they refinance. However, some experts say that today’s slow economy and a historically wide gulf between initial rates on adjustable- and fixed-rate loans are beginning to make a case for the adjustables.
The economy is likely to keep short-term interest rates--which are what many adjustable mortgage rates are tied to--reasonably low for some time. Indeed, some economists think interest rates may fall even further before they start rising again.
Meanwhile, the gulf between rates offered on adjustables and fixed mortgages is hovering near an all-time high, according to HSH Associates, a Butler, N.J., mortgage information service.
On average, adjustable mortgages start out between 1.5 and 2 percentage points cheaper than fixed-rate mortgages. Today, they’re nearly 3 percentage points cheaper.
And at some institutions, the gulf is even wider.
Countrywide Funding, a national mortgage banking firm, recently offered teaser rates as low as 4.5% on conventional adjustable-rate mortgages, for example. The rate for a similar fixed-rate loan started at about 8.25%.
San Francisco-based Bank of America offered an adjustable loan starting at 5%, plus a fee of 1.375 points (a point equals 1% of the loan amount) versus a fixed loan at 8.25% plus a fee of 1.5 points.
In dollars and cents, that means that someone with a $200,000 mortgage would pay $1,503 monthly on the fixed loan versus $1,014 on the adjustable during the first year at Countrywide.
The points--an upfront fee based on the amount of the mortgage--are 1.125% on the adjustable and 0.875% on the fixed, and would total $2,250 and $1,750, respectively, on the $200,000 loan. The net difference favors the adjustable by $5,368 in the first year.
What happens in the second year? The Countrywide loan can jump up by a maximum of 2 percentage points per year. If interest rates rise enough to cause the maximum jump, this loan would go to 6.5% in a year.
On the $200,000 loan, that amounts to monthly payments of roughly $1,264, which still saves the consumer $2,868 annually over the fixed mortgage. (This particular loan adjusts only once annually.)
It isn’t until the third year that this adjustable could start to cost more than the fixed. At that point, assuming interest rates rise by the maximum amount once again, the loan rate would be 8.5%, or $1,538 per month. Now the fixed loan is $35 per month, or $420 per year cheaper.
If interest rates continue in an unrelenting rise, the fixed loan could be a much better deal in the fourth through 30th years of this mortgage. At that point, the adjustable would hit its lifetime interest rate cap of 10.5% and require payments of about $1,830 a month. That’s $3,924 more annually than the fixed.
Still, because this hypothetical homeowner has saved $8,236 in years one and two with the adjustable, choosing the fixed loan doesn’t start saving the consumer money until near the end of the fifth year.
And that’s the worst-case scenario on the adjustable loan.
If rates stay steady or rise more modestly over the next three years, it could take seven to 10 years before the fixed loan starts to be as good a deal as this adjustable.
Consumers who move or pay off their loans before that break-even point--homeowners move every six years on average, according to the National Assn. of Realtors--lose money by choosing the fixed mortgage.
Additionally, homeowners who can afford higher monthly payments can save even more if they play their adjustable loan right.
They’d do that by simply making the same payment on the adjustable as they would owe on the fixed during the first few years.
That would allow them to pay down roughly $8,500 more principal on the adjustable loan by the end of the second year. That affects how much they’d pay over the life of the loan because they’re now paying interest on a smaller principal amount in years three through 30.
Exactly how much can be saved depends on how much is prepaid and what happens with interest rates over the period.
