The New World Of Mortgages

Mortgage rates still hover near their lowest levels in decades. That keeps refinancing near the top of many lists-of-things-to-think-about. If you are one of the millions thinking of refinancing a mortgage, you should know that the rules of the mortgage market changed in the last few years.

Until recently, refinancing didn’t make sense unless current rates were at least two percentage points below your rate and you planned to stay in your home at least five more years. Adjustable rate mortgages made sense when there was a wide gap between adjusted and fixed rates and you didn’t plan to stay in the home for more than five years.

These days refinancing can be profitable when interest rates move less than one percentage point. People also are opting for adjustable rate mortgages more often than in the past,and that’s probably wise for most of them.

The new treatment of refinancing costs is a major reason for the changes. These costs – which can total $1,000 to $3,000 – include application fees, appraisals, credit reports, title insurance, document preparation, attorney’s fees, and settlement fees. In the past, the homeowner had to pay these fees out of pocket. Now, all or most of these fees are absorbed by the lender, added to the loan balance, or factored into the interest rate.

Since a check does not have to be written for these costs, many borrowers ignore them and refinance when they can save a relatively small amount on their monthly payments.

That is not the wisest policy. The fees do cost borrowers money – through either higher rates or an increase in the amount owed. If the fees increase interest rates, then the cost is clear.  You save money if the new monthly payments are less than old payments. When the costs are added to the debt, things are trickier. To see if refinancing is worthwhile, subtract the new payment amount from the old payment amount. Divide that difference into the costs and see how many months it will take you to recover the costs. If it takes more than two to three years, refinancing probably is not worthwhile.

There is another method to use, especially if the costs are added to your outstanding debt.

Determine the number of months left on your current mortgage and multiply that by the monthly payment. That gives you the total cost of the mortgage over its life. Do the same calculation with the proposed new mortgage. If the total cost of the new mortgage exceeds the cost of the old mortgage, you might not want to refinance.

You can make the calculations easily using online calculators at www.bankrate.com or www.hsh.com.

As in the old days, the larger your loan is the greater your savings will be. Also, the longer you plan to keep the loan the greater your lifetime savings.

More refinancerss than usual are opting for adjustable rate loans (ARMs) instead of fixed rates. I suspect many of them are doing the right thing, but not all of them.

One reason to consider an ARM is that the national averages show that the one-year ARM rate is almost 2 percentage points less than the fixed rate. That lower rate is locked in for at least one year. Usually, it takes longer than a year for mortgage rates to rise more than 2 percentage points. The rate would have to rise more than 2 points and stay there for over a year for the ARM to eventually cost more than the fixed rate. That two percentage point gap makes the ARM a reasonable risk.

A reason the gap is this large is that short-term rates, which ARMs are pegged to, have fallen more than long-term rates this year. That is normal when a recession is ending. Long-term rates rise first, and short-term rates rise later when the Fed tries to slow the economy again. At that time, short-term rates are likely to be higher than long-term rates for a brief period. If your ARM’s adjustment occurs at that time, you’ll be paying a high rate than the fixed rate for at least a year.

An ARM of this type can make sense if you are confident of having the income to make higher payments when rates rise. You also should believe interest rates will remain in a normal up-and-down cycle instead of entering a period of steady increases as in the 1960s and 1970s.

Many borrowers also are taking ARMs because they believe low-cost refinancing options will continue. Their plan is that if adjustable rates rise too much and seem likely to continue rising, they will refinance again and lock in the new fixed rate. Unless the mortgage market changes, there won’t be out-of-pocket costs to deter this switch.

There also are new types of mortgages to consider. Many lenders offer a five-year ARM. The interest rate won’t change for five years and the rate is about one percentage point lower than on a fixed-rate loan. In five years, interest rates are likely to have gone through a full cycle of rising and falling. When the rate is adjusted, it might be very close to the current rate.

At the other end of the spectrum are one-month ARMs with current rates less than 4%. The interest rate changes every month based on short-term market rates.

Interest-only loans are attracting people. Merrill Lynch says two thirds of its mortgages are interest-only. The monthly payment is significantly below any other type of loan. These loans usually require full payment in 15 years.

The loan principal never declines and no additional equity is built up. A risk is that the property’s value will decline, making the debt greater than the home’s value. The interest-free loan can make sense if the savings are used to repay higher interest debt or invested for a return higher than the mortgage rate.

Many ARM borrowers no doubt are choosing ARMs simply because the monthly payment is lower. Instead, they should consider these points:

• Don’t take an ARM unless you will be able to afford the payments if interest rates rise sharply. If rates rise and there is a credit crunch, refinancing might not be possible. 

• Make sure you understand how the ARM rate will be adjusted. You want the adjustment to be based on a market rate, not something at the bank’s discretion. Compare the history of the market rate with others. 

• What would the interest rate be today if it were adjusted? Some lenders offer teaser initial interest rates, knowing payments will jump sharply in a year even if market rates don’t change. 

• Does the adjustment use the base interest rate on a specific date or an average over some period? If the rate is based on an average, your rate will lag whichever way market interest rates are heading. 

• Be alert for balloon payments, additions to principal, and deferred payments. Some lenders use these gimmicks to lower your initial monthly payments. They increase your costs long term and could put you in an uncomfortable position when payments are due.