Options When Mortgage Rates Rise
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Mortgage rates went up about half a percentage point in May 2013. That presents a dilemma for homebuyers and homeowners who want to refinance: Pay more each month or find a way to reduce the cost.
The solutions are few, and the trade-offs many, yet borrowers do have some options in addition to the traditional 30-year fixed-rate mortgage. Here are the pros and cons of each.
Play it Safe
Despite the higher monthly payment, a 30-year fixed-rate loan still makes good sense for many home buyers and homeowners, according to Peter Thompson, a senior loan officer with Prospect Mortgage in Naperville, Ill.
"For a lot of people, the fixed-rate is the best way to go," he says. "If you look at the rates right now, they are still historically low."
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The upside is peace of mind that neither the rate nor payment will ever increase. The downside is that borrowers who move or refinance within a few years will forgo the savings they would have realized on a shorter-term loan with an adjustable rate.
Borrowers who have a strong credit score or want to borrow, say, 80% or less of the home's value may be offered a more attractive rate than will borrowers who have a marginal credit history or need a higher loan-to-value ratio.
Shopping around for a loan and paying points are two ways to try to get a lower rate. (A point is an upfront fee equal to 1% of the loan amount.)
Take a Risk
A second option is a "hybrid" loan that's fixed for an initial period of three, five, seven or 10 years, and then converts into an adjustable-rate mortgage, or ARM. The typical difference, or "spread," between the rate on a 30-year loan and the rate on a hybrid ARM makes this type of loan "very desirable," says Leif Thomsen, CEO of Mortgage Master in Walpole, Mass.
The savings can be significant. For example, a $200,000 30-year fixed-rate loan at 4.25% would have a monthly principal and interest payment of $938.88, while a $200,000 5/1 ARM with an initial rate of 3.25% would have a monthly payment of $870.41. The difference, $68.47 a month, totals $4,108.20 over five years.
The risk is that the interest rate may be much higher after the initial term expires. If the rate skyrocketed to the limit, that "would be a disaster," Thomsen says, as the savings would be wiped out within a few years.
Borrowers who choose a hybrid loan typically plan to sell their house, refinance the loan or get a big raise before the rate adjusts. Therein lies the risk because the move or pay hike might not happen, and ability to refinance isn't guaranteed.
An even riskier option is a one-year ARM, which has an initial rate that lasts only 12 months before it begins to adjust, usually annually or monthly.
This type of loan typically has a lower rate than a 30-year fixed-rate mortgage. And lately, the initial rates on one-year ARMs have been higher than the initial rates on 5/1 ARMs in Bankrate's weekly surveys.
Thomsen says the savings on a one-year ARM aren't worth the risk.
"We would never recommend that," he says, "You only have 12 payments at a certain rate, and the difference between a seven-year rate and one-year rate is minimal."
Buy 'Less House'
Borrowers who don't want to make a higher payment or accept the risk of a hybrid or traditional ARM, can trim the cost of the loan by buying a less expensive home or making a larger down payment to reduce the mortgage amount.
For example, the principal and interest on a $220,000 loan at 4.25% would be $1,082.27, and a $250,000 loan at the same rate would cost $1,229.85 a month. The smaller loan saves $147.58 a month. An even smaller loan would mean even more savings, though the trade-off may be a less desirable home.
"People are looking more at what's affordable and what's a payment they can manage," Thompson says. "I don't see that changing just because the rates ticked up."
Use a 'Cash-in' Refinance
Homeowners who want to refinance to get a fixed or lower interest rate, though perhaps not as attractive a rate as they might have been offered a few months ago, can use a similar strategy. In this case, the approach is a "cash-in" refinance, in which the homeowner brings cash into the new mortgage to reduce the loan amount and payment.
The advantage is a smaller monthly outlay and better cash flow. The disadvantage is having to put up the cash, which then cannot be used for other purposes.