Weigh Factors to Decide on Mortgage

By KATHY M. KRISTOF

Aug. 18, 2002 12 AM PT

TIMES STAFF WRITER

A continued slide in long-term interest rates has consumers wondering whether they should refinance their mortgage--often for the second or third time in just a matter of years.

But the proliferation of mortgage products in recent years can leave borrowers mystified about which type of loan best suits their needs. Should they get a loan with a fixed interest rate or one with a variable rate? Or should they try one of the new “hybrid” loans, which charge a fixed rate for three to seven years before switching to a variable rate?

And what about duration? Should they go for a traditional 30-year mortgage or try a 15-year loan, with its higher monthly payments but impressive long-term savings?

The answers depend on a variety of factors: the borrower’s financial situation, how long he or she plans to live in the house and the outlook for interest rates.

Take, for example, a home buyer who believes that interest rates are bottoming out--as they might be. After hitting generational lows last week, the yield on the 10-year Treasury note, a benchmark for mortgage rates, rebounded smartly late in the week. This borrower may feel more comfortable with a fixed-rate loan that locks in today’s low rates.

On the other hand, someone who plans to move within 10 years may benefit from a hybrid loan, which may offer initial rates well below the going rate on a 30-year loan.

“If you know you’re not going to be in your house for more than five or 10 years, there’s no reason to pay more for a 30-year loan,” says Steven Foster, president of Vista Financial Advisors in North Hollywood. “The shorter-term loans can save you a lot of money. I’m all for them.”

Hybrid Savings

The monthly payment on a $200,000, 30-year loan would amount to roughly $1,256, based on a rate of 6.44%. But a hybrid loan with a rate that is fixed for five years and then is adjusted once a year after that can be had for a 5.27% initial rate, says HSH Associates, a Butler, N.J., rate-tracking firm. That would make the monthly payment just $1,107 for the first 60 months--a differential that would save the consumer nearly $9,000 over the first five years of the loan.

Even if the loan rate rocketed 3 percentage points with its first adjustment and remained in the mid-8% range after that, it would take several years for the borrower’s $9,000 in savings to be eaten up by the higher monthly payments, says Keith Gumbinger, vice president with HSH.

“A compelling argument can be made for the five-year product,” he adds. “In reality, even assuming that rates rose sharply, you could go eight to 10 years and do no worse in total costs than you would have done with a 30-year loan.”

The trick is that consumers must be disciplined enough to save that $9,000 rather than spend it, Gumbinger said. If you spent it, the rate hike could blow your budget and leave you feeling poor the moment the fixed-rate period ended.

Anyone considering an adjustable-rate loan should pay attention to the terms of the deal, Gumbinger notes. Most variable-rate loans place caps on annual interest rate adjustments. Usually, those caps promise that the interest rate on the loan will not jump more than 2 percentage points in any one year, nor more than 6 percentage points over the life of the loan.

Given today’s starting rates, that means the worst-case scenario for a person getting a simple one-year adjustable loan would be that the rate could rise from today’s 4.58% to 10.58% in 2005. That would boost the initial $511.45 monthly payment on a $100,000 loan to $921 a month.

Some hybrid loans that stay fixed for several years before the first adjustment allow an even bigger rate hike--perhaps 3 to 4 percentage points--in the first adjustment period. But because homeowners tend to either sell or refinance in less than 10 years, the savings borrowers enjoy in the early years of a five-year or seven-year fixed loan could prove permanent, Foster says.

Common hybrid loans can stay fixed for three to 10 years. However, the longer the fixed-interest period, the closer the rate gets to that of a 30-year fixed-rate loan. The national average rate on a loan that’s fixed for 10 years before becoming adjustable is 6.26%--just 0.18 of a percentage point less than the going rate on a 30-year fixed-rate loan, Gumbinger notes.

On the other hand, those who plan to stay in a home for a long time should take into account that interest rates are near historic lows. If you’re averse to risk and are at a point in life where you don’t plan to move, remodel, or refinance to pay for someone’s college education, sticking with a fixed-rate loan that locks in today’s low rates can be the wiser course, says Floyd Walters, president of BWA Mortgage in La Canada Flintridge.

What about duration? A 15-year fixed-rate loan is generally cheaper--currently offering about a 0.6% break on the interest rate--than a 30-year loan, Gumbinger says. But because borrowers must pay off the balance in 180 payments rather than 360, the monthly payments are steep. The monthly payment on a $100,000, 15-year loan, based on the national average interest rate, would run $836 versus $628 for a comparable 30-year loan.

Those who know they can afford the payments, both now and later, can greatly benefit by using them, Walters says. By getting a loan with a shorter term, a borrower can save tens of thousands of dollars in interest charges.

Evaluate Payments

But those who aren’t certain they can make the higher principal payments should realize that they’re putting their home at risk. If you find you can’t afford the higher monthly payments, you’ll have to refinance or default, which could cause you to lose your home.

For those with uncertain prospects, a better option might be to secure the 30-year loan and just pay it off faster by making larger monthly payments.

“I have some clients who get the 30-year loan and have me run out a 15-year amortization schedule,” Walters says. “Some of them are small-business owners who just don’t know what to expect in the future.”

This strategy keeps the borrower’s options open, he says. On the down side, the slightly higher rate on a $100,000, 30-year loan costs about $40 a month in additional interest.

Still, paying off the principal faster--not the interest rate differential--is what provides the bulk of the savings from a 15-year loan.

Specifically, someone who got a $100,000, 30-year loan at the national average rate, but makes the $836.31 monthly payment that would be required if they had gotten a 15-year loan at the slightly lower 5.86%, 15-year rate, would retire their 30-year loan in less than 16 years at a total cost of $160,378. The cost of paying the 30-year loan on schedule: $226,125, or $65,747 more.

“The big savings is not from the differential in rate--it’s from paying the principal down faster,” Walters notes. “You just have to be disciplined enough to do it.”

To contact Times staff writer Kathy M. Kristof, write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com.

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Mortgage Options

Borrowers can get lower interest rates with shorter-term loans or so-called hybrid adjustables--a great option for those likely to move or refinance again. But those who plan to stay in their homes may prefer the stability of a 30-year fixed-rate loan. Here’s what the different options cost for a $100,000 loan compared with last year.

Monthly Total loan Date Rate payment cost

30-year fixed-rate loan

8/09/02 6.44% $628.13 $226,125.83

8/10/01 7.17 676.76 $243,633.07

15-year fixed-rate loan

8/09/02 5.86% $836.31 $150,536.14

8/10/01 6.72 883.25 $158,984.46

Variable-rate loan, adjusted annually

8/09/02 4.58% $511.45 *

8/10/01 5.94 595.70 *

Hybrid loan, fixed for five years, then adjusted annually

8/09/02 5.27% $553.44 *