Which mortgage would you advise to be the best one at the present time on a $100,000 loan? Mortgage A is a fixed 30-year mortgage at 10 1/2 percent with three points. Mortgage B is an adjustable, which can change every six months based on 2 percentage points above the one-year Treasury bill, with a cap of 2 percentage points in any one year (1 percentage point each time) and no more than 13 1/2 percentage points over the life of the loan. The current rate is 8 3/4 percent and there are no points.
Years ago, borrowers of mortgage loans had very little if any choice in the marketplace. All loans were 30 years fixed, and there was very little competition among lenders.
Now, we have dozens of choices to make. And although we have a variety of mortgages from which to select, in reality there still is very little competition in the marketplace.
Do not suppose that mortgage lenders are going to give you a break. They're in the business of making money, and have carefully figured out what loans make sense to offer, and what loans do not make sense.
One basic rule must be kept in mind when analyzing mortgage loans today. The shorter the term of the loan, the lower the interest rate will be. As you have demonstrated, if you take a six-month adjustable rate, you can get a loan as low as 8 3/4 percent with no points. However, if you take a fixed rate, the best you can get today is 10 1/2 percent. It must also be pointed out that interest rates have been fluctuating for several months, so there is no guarantee that you will be locked in at 10 1/2 percent.
Let's look at the actual monthly payment for each loan. Mortgage A will cost you $896.11 each month, for principal and interest. For the sake of discussion, I will not include the cost of taxes and insurance. Additionally, under Mortgage A, the lender is charging you three points, which is $3,000. Each point is 1 percent of the total loan.
Mortgage B will cost you, initially, no points and a monthly mortgage payment of $786.71. This is a clear saving each month of $109.40, plus the $3,000 out of pocket expense for the points.
It should be pointed out that since you are buying a property, it may well be that you can persuade your seller to pay some if not all of the points. As you know, everything in real estate is negotiable, and it certainly does not hurt to try to get the seller to pick up some of your out-of-pocket expenses.
If you intend to keep the house for just a few years, in my opinion there is no question but that the adjustable rate makes a lot of sense.
But let's look at the worst possible senario. It is conceivable that next year your rate will be 10 3/4 percent, having been bumped up the 2 percentage point cap. Then, your monthly mortgage will be $933.49, which is $37.88 higher than it would have been had you obtained a 30-year mortgage. However, you still are saving because you have not paid any points. Indeed, in year three, your rate can jump to 12 3/4 percent, where your monthly payment would be $1,086.70. Now, the adjustable rate mortgage is going to cost you $190.59 a month more than it would have had you taken the fixed 30-year rate. If you multiply this out over an additional one-year period, you begin to see that you have now eaten into the point savings that the adjustable originally offered you.
This kind of analysis must be made by each borrower before making the commitment. No one can predict the future. I suspect that since next year is an election year, the administration will do everything in its power to keep the interest rates down. However, even in the last year, we have seen that interest rates have jumped up as much as one full percentage point.
The various criteria you should consider include the following:
How long will you keep the house? As we have discussed, if you only plan to keep the house for a couple of years, there is no question in my mind that the adjustable rate makes sense.
Can you afford the higher monthly mortgage payment? If you are on a fixed income, and are concerned that a monthly mortgage payment of 12 percent or 13 percent will not be financially possible for you, then you probably should "bite the bulllet" and take the fixed 30-year rate. If, on the other hand, you are not that concerned about the fluctuating rate, or you anticipate that your salary will increase significantly over the next few years, then again you might be willing to take a gamble on the adjustable rate.
What does your crystal ball show? My crystal ball cracked several yeras ago. I refuse to predict where the economy and interest rates will be in the future. However, if you are a gambler, you might take the adjustable rate. Many people are very happy that they took an adjustable rate several years ago, since the rates went down, as did their monthly mortgage payments.
There is, of course, one solution that may permit you to have your cake and eat it too. Many lenders are offering what is known as a convertible feature on the adjustable rate mortgage. That means that you can initially take out an adjustable rate, and whenever you decide to switch to a fixed rate, you have the option to do so, by the payment of a point or two. Discuss these features with your lender, to make sure that such a option is available to you, in the event you ever decide to take the security of the fixed rate mortgage.
It is important that every potential borrower sit down and do the numbers. There are dramatic differences between loans, and a wrong decision can significantly affect your future and the security of your property. Benny L. Kass is a Washington attorney. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed, stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.