Thousands of American home-buyers are missing out on what could be the mortgage-money bargain of the summer of 1986.
They're lining up in droves for fixed-rate mortgage money -- a product in heavy demand despite rates 1 1/2 percentage points higher than they were three months ago in some markets. They're not lining up at the mortgage-money window where rates have remained stable and low during the same period: the adjustable-rate alternative.
Three months ago, fixed-rate, 30-year mortgages were at 9 1/2 percent or lower, barely 1 1/4 percentage points above national quotes for one-year adjustables. Fixed-rate mortgages were irresistible. Locking up such a loan made overwhelming sense, no matter where you believed interest rates were heading in future years.
Today, by contrast, the "spread" between the two forms of financing has bulged to more than 2 percentage points. Adjustables with impressive consumer safeguards are still widely available at 8 to 8 1/2 percent.
The interest-rate outlook for the U.S. economy suggests a continuation of current stability, or slight declines in the wake of tax revision. Even under the most bearish future economic assumptions, many adjustable-rate plans cost less than fixed-rate loans for several years, and offer no early payoff penalties to consumers who opt to bail out.
Yet the lines at the adjustable-loan counter are shorter than they've been at any time since the early 1980s. Only 15 percent of new mortgage originations nationwide last month were for adjustable loans. That's in stark contrast to the market in mid-1984, when more than 65 percent of all new mortgages were adjustable.
The key reason for the turnaround isn't hard to figure. Given the choice of a traditional, dependable, easily understandable fixed-rate mortgage at moderate cost, American home-buyers overwhelmingly prefer it to the seeming uncertainty of an adjustable-rate loan.
Indeed, for the majority of home-buyers and refinancers, the peace of mind and predictability obtainable from a 10 1/2 percent, fixed-rate mortgage make it the logical choice, despite the lower current rates of the adjustables. Yet for some buyers -- certainly more than 15 percent -- the rate-capped, one-year adjustable should get a much closer look.
To illustrate, compare the economics of a $100,000, 30-year, fixed-rate conventional loan at 10 1/2 percent with those of two common forms of one-year adjustables.
Michael J. Lea, chief economist of the Federal Home Loan Mortgage Corp. ("Freddie Mac"), did precisely that using different interest rate scenarios for future years. What he found should be eye-opening for buyers this summer.
The $100,000 adjustables took the following forms: The first carried an 8 1/2 percent initial rate, plus protective rate caps of 2 percentage points per year and 5 percentage points over the maximum 30-year life of the loan. (Rate caps prohibit year-to-year increases beyond a certain level -- typically 2 percent -- no matter how high rates may have soared during the year. Life-of-the-loan caps prohibit increases beyond a set level -- 13 1/2 percent in this case -- at any time during the borrowers' holding of the mortgage.)
The first loan also carried a "margin" of 2 3/4 percent. The margin is what the lender adds to the one-year Treasury bill rate to come up with each new year's bottom-line charge to the borrowers.
The second $100,000 adjustable came with a more modest 2 percentage point margin, a 12 3/4 percent life-of-the-loan cap, and a discounted 7 percent first-year "teaser" rate.
Even under the worst-case economic scenario, with interest rates rising sharply year to year, the second adjustable was less costly than the 10 1/2 percent fixed-rate mortgage until the fifth year. Even in that year, it cost less than $500 more than the fixed-rate. Under more-likely rate assumptions, the adjustable cost the home-buyers less than the fixed-rate loan until the eighth year.
The first adjustable also performed well against the fixed rate, with lower costs for at least three to four years.
The point, Lea said in an interview, is that rate-capped adjustables "can and will save you money." They make most sense, he said, for buyers or refinancers who know they are likely to stay in their home for no more than five years. These may be first-time purchasers who plan to move up to a larger or better home; people who expect to be transferred or retire; buyers who believe (as he does) that interest rates are more likely to decline than rise over the next several years; and buyers who want to qualify for a larger loan to finance a larger house.
Because of the lower rates, a home-buying couple using a one-year adjustable at 7 3/4 percent today could qualify for a $100,000 mortgage with $34,989 in annual income, but would need $47,044 to qualify for a 10 1/2 percent fixed-rate loan of the same size.