Is low-rate ARM worth volatility?

Q:I am in the military and have a 30-year fixed-rate mortgage in the amount of

$185,000 at 6.50 percent. My principal and interest (P&I) payment is $1,205 per month. The value of the property is $245,000.

I also have a home-equity line of credit with an outstanding balance of $20,000. I have no other debt.

Am I a good candidate for an interest-only LIBOR loan, or should I refinance to a another 30-year fixed?

A: It depends on a lot of things. How long do you plan on holding on to the property? I see that you are in the military. If you will be transferred out of the area in a few years and plan on selling your house, a 30-year fixed-rate loan is a waste of money. But if you plan on holding the home for 10 or more years, you should consider a fixed rate.

The LIBOR adjustable-rate mortgage (ARM) is surely a hot product these days. With the fixed rates spiking in the past couple of weeks, it has become even more attractive.

LIBOR stands for London Interbank Offering Rate. Basically, this is the rate that European banks charge each other for overnight funds. ARMs that are tied to the LIBOR index are popular because the LIBOR is hovering at about 1.10 percent.

The “margin” on a LIBOR mortgage, which is the amount added to the LIBOR in order to determine the mortgage rate, is also typically low, usually around 2 percent.

Adding the LIBOR index of 1.10 and a margin of 2.00 makes the LIBOR mortgage rate only 3.10 percent. Undoubtedly, this is why you and so many others have taken an interest in the LIBOR.

To make things more attractive, most LIBOR ARMs offer an interest-only payment option. This results in exceedingly low mortgage payments because there’s no principal curtailment.

So to answer your question of whether you should consider a LIBOR, let me lay out the details so you can make an educated decision.

A $245,000 LIBOR loan with a current rate of 3.10 percent would require interest-only payments of about $633 per month. Alternatively, a $245,000 loan with a fixed rate at 5.875 percent amortized over 30 years would require a P&I payment of $1,449 per month.

Which is better? As I said, it depends. The LIBOR rate quoted here is based on an index that can adjust monthly. This means the rate can go up or down. Most LIBOR-based mortgages don’t have any reasonable caps on how high the rate can go. Basically, those who take a LIBOR mortgage are at the mercy of future interest-rate volatility.

The fixed rate, at 5.875 percent, is a lot more expensive, but the risk of future rate fluctuations is eliminated. The higher fixed rate means that you are essentially paying for an “insurance policy” against future rate increases.

Is it worth it to pay a higher rate in order to have a fixed term? That depends, as well. If you are fairly certain you will be selling the property in less than five years, for example, it obviously doesn’t make sense to pay for a 30-year “insurance policy.” Consider a product that carries a fixed rate for five years or less.

So, to sum up, my advice would be to take a mortgage that best suits your objectives. If you’re looking for a short-term loan and cash-flow relief, the LIBOR ARM is perfect. It gives you not only the benefit of a rock-bottom rate, but also an option to pay only interest, dropping the monthly obligation even more.

Remember that interest-only payments do not curtail principal, so you don’t lower the debt on the house. However, if you plan on holding the property for a long time and don’t like the idea of being subject to interest-rate fluctuations, now is certainly not a bad time to lock in.

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