- The Washington Times - Friday, January 29, 2010

I’ve been on a roll lately, preaching about the importance of balance and common sense in the mortgage industry. The days of easy mortgage money are long gone, only to be replaced by underwriters who drown perfectly acceptable applicants in senseless paperwork.

This attitude appears to be prevalent when it comes to mortgage programs other than a 30- or 15-year fixed-rate loan. The pundits on business talk shows decry adjustable-rate mortgages (ARMs) and interest-only loans as the cause of the mortgage meltdown. I continue to receive calls from homeowners who have an urgent need to refinance so they can “get out” of their interest-only mortgage without any thought as to the loan’s other features, which may be quite favorable.

Let’s put this into perspective. First, the mortgage meltdown wasn’t caused by ARMs and interest-only mortgage programs. It was caused by the misuse of these programs. Based on the very incorrect assumption that property values always rise, loans were made to folks who intrinsically could not afford the amount they were borrowing.

Loans that offer the option of making only interest payments allow a buyer to borrow about 20 percent more than a loan amortized over 30 years - while still enjoying the same payment. When the housing market was exploding, the interest-only option became very popular. Folks relocating to the expensive Washington area were stung by sticker shock when they realized what a $300,000 mortgage would buy with a 30-year fixed-rate loan. For the same payment, a interest-only loan would allow a loan amount of $370,000.

Is this a bad thing? Well, it depends. If the borrower qualifies for an amortized payment on a $370,000 loan, he should be able to pay the interest-only loan down if he chooses to do so. On the other hand, if the interest-only payment is the highest payment he can afford, he’s probably trying to borrow too much.

The amount of equity in a home is another factor that should determine whether an ARM or interest-only loan is appropriate. Common sense should determine whether the loan is practical. A first-time homebuyer seeking to borrow as much as possible with a low adjustable rate and an interest-only payment and no money down is an obvious red flag. This scenario would be a classic misuse of a mortgage program.

Let’s contrast this situation with a recent refinance client of mine. This fellow is carrying a fixed-rate loan in the amount of $1,045,000 secured against his house that’s worth more than $2,500,000. His interest rate is 6.375 percent and allows interest-only payments for eight more years before converting to an amortized loan.

He called me to ask about refinancing. He said he is retiring in less than seven years and will be selling his home. He wants to lower his rate and his payment.

I suggest he take out a 7/1 ARM at 4.375 percent with amortized payments. After running the numbers, I tell him this program drops his payment by $282 per month. Because the loan is curtailing principal, his mortgage balance drops by $138,000 over a seven-year period, resulting in a net savings of almost $162,000.

If he wants to lower his required monthly payment even more, he can choose a 7/1 interest-only ARM carrying a rate of 4.75 percent, dropping his payment (and interest costs) by $1,363 per month, resulting in a savings of more than $114,000 over seven years.

Since the loan amount is less than 50 percent of the home’s value, and the borrower’s plan is to sell the house before the ARM adjusts, there is no reason in my mind why this fellow shouldn’t take advantage of this low ARM. This is a practical and smart use of an adjustable-rate mortgage.

Henry Savage is president of PMC Mortgage in Alexandria, Va. Reach him at henrysavage@pmcmortgage.com.

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