- The Washington Times - Thursday, May 13, 2004

Q:We have just finished remodeling our home in Baltimore. Our

current mortgage balance is $322,000, and our house should appraise for more than $400,000.

Our interest rate is 8.25 percent, and our private mortgage insurance payment is $267 per month. Excluding taxes and insurance, our monthly payment is $2,761.

The construction on our home took many more months than we originally anticipated, and we spent an additional $30,000 finishing the job, which is now on our credit card.

Can you offer us some advice as to how we should go about refinancing this property? Should we take cash out to eliminate the credit-card debt?

We don’t see ourselves in this house more than five years, so should we take out an adjustable-rate mortgage? My wife doesn’t like the idea of an ARM because of the rising interest rates.

Basically, we know we should probably do something, but we don’t know where to start.

A: Your situation provides a good opportunity to discuss the advantage of low-interest-rate ARMs, even in a rising-interest-rate environment.

An ARM allows a borrower to pay a lower interest rate in exchange for absorbing some future interest-rate risk.

If you don’t like the idea of the possibility of your rate rising in the future, you must be prepared to take a fixed rate, which will carry a higher rate.

Here are some simple numbers: You might find a 30-year fixed rate today at about 6 percent.

On a loan of $322,000, be prepared to pay $1,931 in monthly principal and interest.

A 5/1 ARM, which carries a fixed rate for the first five years and adjusts annually thereafter, will start at about 5 percent, creating a P&I payment of $1,729 per month.

For the first five years, the borrower pays $202 less each month by taking the ARM.

This is a guaranteed total savings of $12,120 over five years ($202 X 60 months).

Obviously, if interest rates happen to be low in five years, the ARM rate will stay low in year six. But if interest rates are high at the time of adjustment, the ARM holder will have to pay a higher rate — perhaps more than 6 percent.

This is the problem with ARMs. The borrower simply doesn’t know because interest rates cannot be accurately predicted. The only thing the borrower knows is that if he takes the 5/1 ARM, he’s ahead of the game by $12,120 before rate adjustment.

Because you see yourself selling in five years or less, why would you take out a 30-year loan? At the very least, I would recommend refinancing to a 5/1 ARM instead of a 30-year fixed rate.

Your situation requires a bit more analysis. You’ve racked up $30,000 in credit-card debt during the construction of your home. This debt must be taken into consideration in your refinancing decision.

In order for you to take out a mortgage loan for $352,000 to pay off the credit-card debt, your property would have to appraise for at least $440,000, indicating that you have 20 percent equity. That may not be in the cards.

Once you obtain an accurate appraisal, a good loan officer will be able to advise you in that area.

But let’s assume that your property doesn’t appraise that high. Your mortgage balance of $322,000 is 80 percent of $402,500. This is the minimum value needed to eliminate private mortgage insurance.

Is the 5/1 ARM the best product to choose even if I have $30,000 in outstanding credit-card debt? Probably not.

Consider a monthly ARM. This might sound crazy in light of the rising rate environment, but hear me out.

A monthly ARM tied to the LIBOR index (that’s London interbank offering rate) is now hovering at about 3 percent.

Most LIBOR-based ARMs offer an interest-only payment option, which allows for a very low monthly payment.

Three percent of $322,000 equals $9,660 per year, or a monthly payment of only $805.

Instead of dropping your monthly payment from $2,761 to $1,729, you can drop it to $805. That will free up $1,956 per month in monthly cash-flow obligations.

Applying $1,956 per month to the credit-card debt will eliminate it fairly quickly.

Moreover, your mortgage balance didn’t rise by $30,000.

The downside? It’s a monthly ARM. Two years ago, the LIBOR ARM was carrying a rate of about 4 percent. It has steadily declined since.

By most accounts, you can expect this rate to start rising. But let’s look at the facts.

First, it’s a slow-moving ARM, meaning the rate is not likely to spike.

Second, with a current rate of about 3 percent, it has to double before it hits the current fixed rate of 6 percent. This will surely take a long time, perhaps more than five years.

Third, interest rates may rise but aren’t likely to skyrocket.

A good loan officer should be able to discuss your situation in more detail to determine if such an ARM would be in your best interest.

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

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