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November 11,
2001
"My
broker has offered me the following 6% loans: a 30-year fixed-rate at 1.125
points; a 7/1 ARM at 1 point; a 7-year balloon at 0.375 points; a 5/1 ARM at
.875 points; and a 5-year balloon at 0 points. How do I decide which mortgage is
best for me?"
You have made a
good first step. By standardizing the interest rate at 6%, the price
differences are entirely in the points. (One point is 1% of the loan amount).
These price differences are related to risk differences between these
options. The question is, which combination of price and risk is best for you?
The broker left
out the 15-year fixed-rate mortgage (FRM), perhaps because you can�t afford
the payment. The payment on all the
others is based on a repayment period of 30 years.
On the day you were quoted the rates above, a 6% 15-year loan carried a
rebate of 1 point � that�s 2.125 points less than the 30-year fixed.
From a price and risk standpoint, the 15-year is the most attractive of
the options, but the borrower must be able to handle the payment.
The 30-year FRM
generally has the highest price because it carries the most risk for the lender.
If interest rates rise significantly, the lender is stuck with a
relatively low rate for what could be a very long period.
For the same reason, this loan carries the least risk to the borrower.
What is striking
about the prices quoted to you, however, is how little it would cost you to
obtain this protection. Compared to
an adjustable rate mortgage (ARM) on which the initial rate holds for 7 years,
you must pay only .125 points more for the 30-year FRM.
At that price, you should select the 30-year FRM if there is any chance
that you might still be in your house after 7 years.
However, the price
of protection quoted by your broker is too low to be representative.
When I shopped 30-year FRMs and 7-year ARMs offered by the same lenders,
I found price differences ranging from .7 to 1.4 points when the rate was the
same. Your mortgage broker mixed
and matched from different lenders, which sometimes reveals strange bargains.
At the higher
price differences that I found, selecting the 30-year FRM is no longer a
slam-dunk. It depends on how likely
it is that you will still be in the house after 5-7 years, and how much risk you
are willing to take.
Assuming you
decide against the 30-year FRM, the choice between an ARM and a balloon hinges
on the same factors. The balloon is
priced lower because it has less risk to the lender, and therefore more risk to
you, than the ARM.
At the end of the
5 or 7 years, the balance on a balloon loan must be repaid.
If market rates increase markedly over the period, the lender will be
able to reinvest at the market rate, and the borrower will have to refinance at
the market rate.
The borrower with
an ARM, in contrast, has some protection against an interest rate explosion.
Virtually all ARMs contain maximum lifetime rates, caps on the size of
any rate change, or both. The new
ARM rate, therefore, will probably be below the market.
Between
1976 and 1981, for example, mortgage rates increased by about 9%.
A borrower with a 5-year balloon that came due in 1981 had to pay about
9% more for another balloon. In
contrast, a borrower with a 5-year ARM that had a 2% adjustment cap and a
maximum rate 6% above the initial rate, paid 2% more in each of the years 1981,
1982, and 1983.
A
rate explosion within the next 7 years is unlikely but possible.
The question is whether the protection provided by an ARM is worth the
added cost of .625 points on the 7-year, and .875 points on the 5-year?
Only you can answer that.
If
you elect the balloon to save money, the 5 versus 7 is a close call.
With a price difference of .375, you could go either way.
If
you elect the ARM, the price difference of only .125 points between the 5 and
the 7 appears very low for two years of extra protection.
However, ARMs may differ in other important ways, including rate caps,
that need to be considered.
Copyright
Jack Guttentag 2002
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