Lew Sichelman
Rising mortgage rates are sidelining many would-be homebuyers. But there are two ways to meet the challenge.
One option – paying “points” and lowering the rate for the life of the loan – is costly at first, but could be less expensive in the end. The other option – adjustable-rate mortgages, whose rates start lower but can increase – is cheaper at the start, but might ultimately cost more.
The key to both options is how long you plan to stay in the house – or, alternatively, how long you have to hang on to the loan before it makes sense to refinance. As usual, you must do the math to determine which is best for your circumstances.
A point is 1 percent of the loan amount. So, if you have a $300,000 mortgage, a point is equal to $3,000. And each point paid buys a permanent reduction in your rate. Here’s an example worked up by Patrick Casey of Fulton Mortgage in Chevy Chase, Maryland, based on his company’s current rate sheet.
Say you’re looking at a 30-year fixed-rate loan at 5.75 percent on that $300,000 house. If you paid a point upfront at closing, you could buy the rate down to 5.375 percent. That 0.375 percent difference would lower your monthly payment for principal and interest from $1,751 to $1,680 – a difference of $71 each month.
Now, most of us don’t have thousands of extra dollars lying around, and most buyers – especially first-timers – want to cut their initial outlay, not increase it. But for move-up buyers selling their old places at top dollar, paying points is something to consider.
“Sometimes it pays to pay,” said Casey.
How to Spend Your Extra Cash?
If you have the extra money, you should figure out how long it would take to recoup your investment in points, which is where the arithmetic comes in.
In the above example, it will take 42 months. That is, by dividing your savings into your cost – $71 into $3,000 – you find that in roughly 3 1/2 years, you will have made good on your extra investment. After that, it’s all gravy: Remember, your rate never changes.
Another alternative is to add that $3,000 to your down payment, bringing the mortgage down to $297,000. But in that case, your payment would be just $53 a month lower and you wouldn’t break even until 56 months go by.
The choice is yours. You might decide to just keep that $3,000 in your pocket. But if you’re after the lowest payment possible, your decision should depend on how long you expect to keep the house before selling or refinancing.
If you’re in it for the long haul, it would make sense to buy a point or two – if you have the cash. But if you believe you’ll move on in three years or less, keep your wallet closed.
An ARM is an Option
Whether or not to opt for an adjustable-rate mortgage also rests, at least in part, on how long you plan to remain in the house. But in this case, short-termers are the main beneficiaries.
Like their name suggests, ARMs come with rates that adjust at various times. The rate can go up or down annually – or less often, such as every three, five or seven years, depending on the loan. But ARMs come with safeguards so that the rate doesn’t rise by too much at each adjustment, nor over the life of the loan.
In today’s market, a 7/1 ARM is popular: The rate remains set for seven years, then adjusts annually after that. At the first adjustment, it could go up by as much as 5 percentage points, depending on the market at that time, but it can never go any higher. If the rate doesn’t adjust by that much on the first ratchet, it can jump 1 percentage point each time – but again, never by more than 5 points over the life of the loan.
The benefit is that the rate on ARMs start somewhat below the market. That’s why there’s been a rush on these of late: Earlier this month, 11 percent of all loan applications were for adjustable mortgages, the Mortgage Bankers Association reports. And the “introductory” rate on a 5/1 ARM – one that remains set for five years and then adjusts annually – was 4.47 percent, as opposed to 5.53 percent for a 30-year fixed-rate loan.
Let’s look again at our $300,000 mortgage, this time as a 7-year ARM with 5/1/5 rate caps. Based on Fulton Mortgage’s rate sheet, the monthly principal and interest payment would be $1,543. That’s a $208 savings over a 30-year fixed-rate mortgage at 5.75 percent.
Buyers Make a Bet
So, are you a gambler? No one knows where mortgage rates will be next week, let alone seven years from now. If our hypothetical loan were to adjust today, the rate would jump by the maximum allowable 5 points, bringing it well over 9 percent. Then again, it might never get that high.
The question, then, is: How long do you keep the loan, or the house? If you expect to move within seven years, you are ahead. If you stay longer, you could lose, depending on future rates. You could refinance, but rates could be even higher then, or your financial situation may have changed so that you wouldn’t qualify.
Remember: The examples here are based on one lender’s offerings; every lender has different pricing structures and rates. It’s always wise to shop around.
Lew Sichelman has been covering real estate for more than 50 years. He is a regular contributor to numerous shelter magazines and housing and housing-finance industry publications. Readers can contact him at lsichelman@aol.com.
