Loan choice hinges on trade-offs

Q: I would like some advice on purchasing a new home and what mortgage would be best suited for me.

I’m looking to buy a home with my wife and two young children. I recently sold my town house and made about $180,000 in equity. I would like to use this equity as a down payment on a new home that costs $488,000.

I want to stay in my new home for more than five years, but I don’t think I can afford a 30-year fixed rate. I make about $48,000 a year and have an excellent credit record.

Would you recommend a 10/1 adjustable-rate mortgage? Basically, I want the lowest monthly payments for as long as possible. I have some reluctance about the interest-only loans because I do not want to be hit with higher mortgage payments that I can’t afford.

A: When it comes to choosing the right mortgage program for your particular situation, understand that everything’s a trade-off. The familiar expression — you can’t have your cake and eat it, too — is a perfect description.

A low monthly payment will, unfortunately, require some sacrifices. A 30-year fixed mortgage is the safest — no worries about rate or payment increases.

The bad news is that a 30-year fixed-rate loan will carry the highest interest rate and require the highest monthly payment.

An interest-only mortgage allows a payment that doesn’t curtail any principal. The good news? A low monthly payment. The bad news? Your mortgage balance never drops.

An adjustable-rate mortgage carries a lower interest rate and results in a lower payment. That’s the good news. The bad news? An ARM is subject to rate increases, depending on market conditions.

I think you’re on target with a 10/1 ARM, or even a 7/1 ARM. These programs, called “interim ARMs” carry fixed rates for the first 10 or seven years, respectively. After the initial period, the rate will adjust annually according to market conditions at the time. The shorter the initial fixed period, the lower the initial rate.

It’s a risk vs. return thing. The longer the time that the borrower is shielded from interest-rate fluctuations, the higher the initial rate. You say that you’d like to stay in the home for more than five years. Do you have a more specific plan? What are the chances that you will sell within seven years? Ten years? Answering these questions the best you can will help you make a better decision on the right mortgage product.

The purchase price is $488,000. You plan on putting down $180,000. This will require a mortgage of $308,000. I can tell you that this is a lot of money to borrow on only a $48,000 income. Indeed, you probably would not qualify for the most competitive 30-year fixed-rate loans.

My calculator tells me that a 30-year fixed-rate loan would probably cost you about $2,200 per month, including taxes and insurance. Most folks would need more than a $48,000 annual income to afford this house payment.

It’s back to the drawing board. A 10/1 ARM might drop the rate by a quarter-percent or so. Unfortunately, your payment will decrease by only about $50. A 7/1 ARM would decrease the payment by perhaps $100.

A 7/1 ARM with an interest-only payment option would significantly drop your required payment. My calculator tells me that under this scenario, your required payment would drop to about $1,800, including taxes and insurance.

Here’s my advice: Ascertain your payment comfort level before you choose your house. A good loan officer can then lay out the menu of mortgage programs and how much each program will allow you to borrow.

Then decide on how much of a trade-off you are willing to make.

Consider the future. For example, if your income is likely to increase in the years to follow, an ARM with an interest-only payment might work.

On the other hand, if you are very risk averse and only want a 30-year fixed rate, you will need to lower your sights and buy a cheaper house.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-(henrysavage@pmcmortgage.com).