> Buyers' Advice
Taking An ARM When Rates Are Rising? Are You Crazy?
by Henry Savage
Well folks, it appears that interest rates are finally headed north. Since last December, economists have been predicting that interest rates will rise in 2004. Up until only a few weeks ago, the experts have been wrong. Mortgage rates fell sharply in early 2004 but have since spiked up after a series of positive economic news. Last February, thirty-year fixed rates were hovering around 5.50 percent. Today, you might find 6.25 percent. This is the subject of today's column. Is it unwise to take an adjustable-rate mortgage during a period of rising interest rates? I hear it in the news, I see it in the papers -- "Lock your rate now before it's too late". Understandably, people tend to press the panic button when interest rates rise. They don't want to be caught with an adjustable-rate mortgage for fear of a higher rate in the future. This makes plenty of sense in some cases, but certainly not in every case. The situation regarding a recent client of mine perfectly illustrates the notion that everyone's situation is different. These folks just finished remodeling their home in Baltimore. The project took many more months than originally anticipated and cost $30,000 more than their budget, creating a nasty credit card balance. Here are the basics: The property is worth about $410,000 and their current balance is about $322,000. Their rate is 8.25 (fixed) and they're paying private Mortgage Insurance (MI) of $267 per month. Excluding taxes and insurance, their mortgage payment is $2,686 per month. These folks come to me with the idea of refinancing to a new lower fixed rate and eliminating MI. I tell them I can lower their rate to 6.25 percent and indeed eliminate the MI. This will save them about $700 per month. It makes plenty of sense, but is it indeed the best plan of action? Probably not. The first logical question a loan officer needs to ask before determining the best mortgage program is how long the borrowers plan on owning the property. They tell me that it's very likely that they will sell within five years. So instead of a fixed rate at 6.25 percent, I suggest a 5/1 ARM at 5 percent. This rate is fixed for the first 5 years and adjusts annually thereafter. If you are going to sell within 5 years, why would you take out a 30-year loan? That's akin to taking out an insurance policy that you know you'll never need. At 5 percent, they save an additional $255 per month over the next 5 years. That's a total of $15,300. But this situation requires a bit more analysis. They have racked up $30,000 in credit card debt during the construction of their home. I hate credit card debt -- it has no tax advantages and is generally very expensive. Therefore, this debt must be taken into consideration before making a refinancing decision. Eliminating credit card debt should always be a priority. So I suggest a monthly LIBOR ARM. This may sound crazy in light of the rising rate environment, but hear me out. A monthly ARM tied to the LIBOR index (that's London InterBank Offering Rate, and can be explained in a separate column) is currently hovering at about three percent. What's more is that most LIBOR-based ARMs offer an interest-only payment option. The combination between a low rate of three percent and an interest only feature allows for a very low monthly payment. Three percent of $322,000 equals $9,660 per year, or a monthly payment of only $805. This would drop their mortgage payment from its current level by $1,881 per month. Applying the $1,881 per month to the credit card debt will eliminate it fairly quickly. Moreover, the mortgage balance doesn't rise by $30,000. The downside? It's a monthly ARM. Two years ago the LIBOR ARM was carrying a rate of about four percent. It has steadily declined since. By most accounts, however, you can expect this rate to start rising. As I said, obtaining a monthly ARM during a period of rising rates may sound crazy, but let's look at the facts. First, it's a slow moving ARM, meaning the rate is not likely to spike up quickly. Second, with a current rate of about three percent, it has to double before it hits the current fixed rate of six percent. This will surely take a long time, perhaps more than five years. Third, interest rates may rise a bit, but are not likely to skyrocket. And last, my clients will very likely eliminate their insidious credit card debt, thanks to the LIBOR's low rate and payment. The only thing that history has proven about interest rates is that they are dynamic. When they fall, they will eventually rise. By the same token, when they rise, they will eventually fall. | 
