In recent years, fixed-rate mortgages have lost popularity as interest rates sank and home buyers were unwilling to pass up the opportunity to save on their mortgage payments even over the short term. The situation has begun to shift, however, and it’s time for buyers to take a closer look at the classic, fixed-rate mortgage as a serious option.
The ARM (adjustable-rate mortgage) and all of its exotic and hybrid relatives has become the norm for simple economic reasons. In order to allow consumers to lock in an interest rate over a 10- to 30-year period—standard fixed-rate durations—banks and other lenders had to demand a higher interest rate overall. Remaining solvent is key for everyone in the money business, and it would not work for a lender to offer the lowest rate available and promise to maintain that rate without increase while interest rates overall are fluctuating wildly. Thus lenders have to make sure that rising rates won’t catch them short. Money lent at 6% for 30 years is tied up with no hope of more income being gained from it.
ARM’s, on the other hand, allow lenders to maximize profit at a time when rates are rising and allow borrowers to minimize risk as they can be assured that, depending on the formula they’ve opted for, their rate will be the lowest possible at any given time. A 3/1 ARM remains static for three years, then adjusts every year after that. If rates are rising, that’s three years at a lower rate before the borrower has to play catch-up at a higher rate. A 5/1 ARM is static for five years, and so on. The first number in the formula represents a variation on the fixed-rate mortgage, as it specifies the number of years during which the rate and payments will be locked in at the original contract level.
For the past decade, mortgage interest rates have dropped rapidly in response to several factors. As a result, the housing market has boomed, creating the “bubble” of rapid price increases and rabid new-home construction. With rates in the neighborhood of 5%, many buyers who couldn’t afford a $200,000 mortgage at a higher rate jumped into the market and locked in as many as 5 years at the lowest rate they could negotiate.
But the interest rate appears to have bottomed out. The current trend is upwards, with Freddie Mac, the country’s largest secondary market mortgage company, reporting May, 2006, interest rates at 6.22% with a distinct upward trend apparent over the past six months with a low of 5.76% in January. Given the direction mortgage interest rates are taking, home buyers who agreed to a 3/1 ARM a year ago may well be in for a shock in another year when they find that their payments will be adjusted drastically to accommodate the difference. Meanwhile, those buyers are in a negative amortization situation, where they will owe more after each payment than they did prior to sending in the money.
Meanwhile, fixed-rate mortgages have seen very minor interest-rate changes since 1971. They have hovered 7.31 % in April, 1971 and 6.60% in May, 2006. That’s 6.6% locked in for 30 years as opposed to 6.22% locked in for only 3 to 5 years with an unknown change to follow at the end of that period. Given that 1981 saw fixed-rate mortgage reach an all-time high of 16.83%, and given that inflation is nearing crisis levels now as it was then, there is no guarantee that that 5.x% ARM won’t jump to double-digits somewhere down the line.
Why is this critical? Because most home buyers in the current market are over-extended, having borrowed the maximum they could manage while interest rates were low enough to keep their mortgage payments within reach of their incomes. Judging by the foreclosure rate, few of them were wise enough to set up a saving plan that would ensure that when the rates rose and their mortgage payments jumped they’d have the money to either pay off the mortgage in its entirety or accommodate the higher numbers.
Refinancing has become a way of life for many borrowers. This might be the right time for a refi if your mortgage payments will be beyond your ability to pay should the rate go to 9%, 10% or higher. Now is the time to make the calculations, take a hard look at the situation, and think about locking in that slightly higher but infinitely more stable 7.31% for as many years as you think you’ll need. Make an appointment with your lender or a trusted accountant and be merciless in your judgment. The cost of a refi with a long-term fixed-rate mortgage as the goal might be just what you need to keep you and your family in your home and out of bankruptcy.
Posted by ebruce 