As mortgage rates flutter back into single digits for what could be a short-lived break before spring, borrowers should bear in mind the 1988 market's most fundamental rule: Shun gimmicks.
Avoid the bumper crop of tricky new mortgages -- fixed-rate and adjustable -- that look and sound seductive but could sting you. The best current example is one you've probably seen advertised or heard of locally. It's been ballyhooed from coast to coast under names such as the Peace of Mind Loan, Reduction Option Loan (ROL), Reducing Interest Mortgage (RIM) and similar promotional tags.
The "peace of mind" of the ROL arises from the fact that the loan rate "cannot go up, but it can go down," in the words of one breathless advertiser.
Pioneered late last year by Shearson Lehman Mortgage Corp. and duplicated last month by other lenders, the mortgage now is available from dozens of firms. The behemoths of the home-lending industry -- the Federal Home Loan Mortgage Corp. (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae) -- both buy them from local originators. Freddie Mac has agreed to purchase as much as $1 billion worth of them. And its top official, Leland C. Brendsel, has said reduction-option loans "will gradually replace many of the standard, fixed-rate mortgages that are being made."
Don't bet on it. At least not in the loan's present configuration. Here's how it works:
Take a standard 30-year, fixed-rate mortgage. Add from one-fourth of a percentage point to three-eighths of a percentage point to the basic mortgage rate consumers pay for straight fixed-rate loans. Also add extra "points" -- anywhere from one-fourth to three-fourths of a percent of the mortgage amount -- payable in cash up front from the loan proceeds.
Having packed all this extra pricing into the loan, next add the seducer, the gimmick. Then you market it aggressively and de-emphasize the higher rates and points.
The gimmick: the consumer's ability to refinance the loan at a future date at a fraction of the customary costs. Rather than risk waiting for a cyclical low point in rates before getting your mortgage, you can sign up for a peace-of-mind loan anytime.
Then when rates are lower and it makes sense to refinance, you can do so cheaply. Rather than forking over 1 percent to 4 percent of the mortgage amount for refinancing charges -- appraisal fees, points, credit checks, etc. -- you can pay just $100 plus one-fourth of a point. That's the guaranteed maximum cost under the most popular version -- $350 on a $100,000 mortgage, rather than $1,500 or more.
It sounds good. And under certain conditions, it may even be good for some borrowers. But does it make sense for 1988's spring rate break, or even the 10 percent to 11 percent market that could return later this year?
Take a second look. For starters, the borrower cannot activate the refinancing "option" unless interest rates on conventional fixed-rate mortgages drop 2 percentage points or more below the rate on the borrower's note. Moreover, the refinancing can't just take place any time. It has to occur within a carefully prescribed time limit -- from the 13th month through the 59th month of the loan. Finally, when and if you do refinance, you can't "cash out," that is, pull out some inflation-fed equity through a larger loan amount.
So how does that stack up as a loan package for 1988 consumers? Not well.
Question No. 1 for borrowers who can put aside the "peace-of-mind" glitz should be: Do I want to pay what are essentially monthly insurance premiums to avoid future expenses that I can easily avoid anyway?
Question No. 2: Do I want to pay a higher mortgage rate for 30 years in the hopes that some day -- but only between months 13 and 59 -- other people's rates drop by 2 percentage points? And do I want to be locked into a refinancing option that will prevent me from tapping the most important tax-free source of cash available to American homeowners -- their growing equity?
The answers aren't tough to come by.
From the lender's side of the ledger, the ROL mortgage is a charm. Borrowers pay a premium rate from day one -- almost one-half a percentage point higher -- for services the lender may never provide. They even pay higher cash up front at closing.
And how likely is it that 30-year mortgage rates will drop below 8 percent between mid-1989 and 1993? Judith Naimon, Freddie Mac's director of product strategies, argues that recent years have shown "very wide swings in rates" -- 2 or 3 percentage points within a year's time. But even optimist Naimon concedes that the prospects for puncturing the 8 percent barrier are dicey at best. The higher the rates in the marketplace overall, she says, the more attractive the ROL mortgage will prove to be.
That remains to be seen. Some mortgage investors say they'd want even higher rate premiums and fees in a higher-rate environment, given the greater likelihood that borrowers would indeed refinance into lower-rate alternatives.
What should that tell you? Until lenders turn the ROL mortgage into a peace-of-mind plan for consumers -- not just themselves -- don't touch it.