- The Washington Times - Friday, March 28, 2008

Q: My wife and I took out a five-year balloon mortgage in 2003. The rate is only

4.50 percent and has been great.

Since five years is almost up, we received a letter from the lender explaining that we need to pay off the loan or convert it to a fixed-rate loan for the next 25 years.

They are offering the conversion at 6.75 percent with a $500 fee. The balance is now $292,000, down from the original balance of $320,000.

From your column, we understand that you do not recommend paying points when refinancing in order to receive a lower interest rate.

Is this your recommendation for us? If we accept this conversion, our payment will go up by almost $400 per month. Or should we refinance, pay points and grab a lower rate and a lower payment?

A: My recommendation would be neither of those options. You have given me enough information to really dissect your situation. Let’s do so.

The mortgage program you have is known as a 5/25 Two-Step. The program typically carries a low rate for the first five years and is repaid based on a 30-year amortization. At the end of the five-year period, the borrower must either pay off the loan or convert it to a new fixed rate that will be paid off over the remaining 25-year term.

The rate and payment invariably increase after the initial period.

Your numbers make sense after verifying them with my calculator. A $320,000 loan, amortized over 30 years at 4.50 percent creates a principal and interest payment (P&I;) of $1,621 per month.

At the end of five years, you would have paid down the principal to about $292,000.

The second “step” of the two-step loan is to pay the balance off at a new rate that’s calculated with a predetermined formula for the remaining 25 years.

A $292,000 loan with a fixed rate of 6.75 percent amortized over 25 years will create a P&I; payment of $2,017. This explains why your payment shoots north to the tune of $396.

Scrap the conversion. Simple number crunching will also explain why you should scrap the idea of buying your interest rate down through the payment of points and closing costs.

I see that a 30-year fixed rate of 5 percent will cost 3 points plus transactional fees. Since 1 point is equal to 1 percent of the loan amount, we are already nearing $9,000 in points payments.

Add typical closing costs such as appraisal, title insurance and attorney fees, and we can tack on another $3,000, making the cost of a 5 percent rate about $12,000.

Assuming you are not prepared to pay these fees out of pocket, we would roll them into the loan amount, increasing your balance from $292,000 to $304,000. The principal and interest payment at 5 percent amortized over 30 years is $1,632 — an $11 difference from your original payment.

However, it costs you $12,000 in nonrefundable fees. That’s not a good deal.

My advice remains as it always does: Take out a zero-closing-cost loan with no prepayment penalty. I see that a current market rate for a 30-year fixed is running about 6 percent. Amortized over 30 years, the P&I; payment becomes $1,751. Even though this is $130 more than the original payment, the balance can remain at $292,000 because there are no fees associated with the refinancing.

Remember that the modest increase in payment is a function of the new loan’s enabling you to pay the loan over 30 years, instead of the 25 years as required by the two-step program. This is not necessarily a bad thing, but it’s important that the borrower know and understand his mortgage program and the terms of the payoff.

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

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