- The Washington Times - Thursday, August 12, 2004

Q: We are considering refinancing my fixed-rate loan to a monthly adjustable-rate mortgage. My rate will drop from 6.25 percent to 3.50 percent. What’s even better is that my payment will be cut by more than half because the mortgage allows interest-only payments.

Since we are virtually certain that we will be selling in about two years, we think this would be a good move. We would appreciate your opinion.

A: Indeed, the latest popular trend among mortgage products is for interest-only adjustables. I receive e-mails daily from folks around the country inquiring about these loans.

Although I recommend interest-only ARMs to some clients, they are not for everyone. As I have said many times before, there is no one particular mortgage product that suits everyone.

Having said that, it appears that you are making a wise decision to convert your fixed rate into a monthly ARM. Here’s why:

• Your interest rate drops from 6.25 percent to 3.50 percent. This is a significant interest savings.

• You recognize that you don’t need the stability of a 30-year fixed rate because you will be selling in two years. There’s no need to pay for a 30-year rate protection.

Let me show you the numbers.

The principal-and-interest payment at 6.25 percent on a $375,000 mortgage is $2,309 per month. An interest-only payment at 3.50 percent is $1,093 per month, resulting in a cash-flow reduction of $1,216. With borrowing costs as low as 3.50 percent — and tax deductible, I might add — there’s surely some wisdom in taking out such a loan.

Now let’s review the downside. First, you will be taking out an ARM that can adjust every month. This gives you absolutely no interest-rate protection. Technically, your rate could rise significantly every month. You must understand that this possibility exists, albeit improbably.

Actually, the economic experts are predicting a gradual rise in interest rates. If they’re correct, your 3.50 percent will disappear. Still, the ARM needs to increase by 2.75 percent before it equals your current rate of 6.25 percent. That’s a big jump. Is it likely to do so in the next 24 months? It’s possible, but I doubt it. In the meantime, your interest savings are considerable.

Because you are considering a refinance from an amortized loan to an interest-only mortgage, it’s important to realize that your $1,216 does not reflect a pure interest savings. Your current loan is curtailing a little bit of principal every month, while an interest-only loan does not.

If you were to amortize the 3.50 percent loan over 30 years, the P&I; payment would be $1,684 — a difference of $625. This more accurately reflects the true savings in interest costs.

The bottom line in deciding whether to take out an interest-only ARM is simple: Establish your objectives and understand the product. This will lead you to the right course of action.

Two more things: As in all refinance transactions, beware of the closing cost expense. Make sure your costs are not so high that it defeats the purpose of the refinance. Also, watch out for prepayment penalties. If the loan carries a prepayment penalty, make sure it’s one you can live with.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail ([email protected]pmcmortgage.com).

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