- The Washington Times - Thursday, September 2, 2004

Q:I have a 30-year fixed-rate mortgage with a balance of \$150,000 at 5.75

percent. I have been offered a LIBOR loan that allows interest-only payments for the first 10 years and converts to a fixed rate for the remaining 20 years.

The rate is 3.75 percent with two points.

My loan officer tells me I would be saving \$250 per month right away. If I pay extra toward principal every month, he says, my balance will be very low in 10 years.

That 3.75 percent sounds great. Is this something you would advise?

A: Although I’m a big fan of the LIBOR loan in certain situations, it’s not for everyone. From the context of your question, it appears that you may not fully understand the program being offered.

LIBOR stands for London Interbank Offering Rate. Basically, this is a rate that European banks charge one another for borrowing short-term funds.

When we talk about a LIBOR-based mortgage, we are talking about an adjustable rate that will move along with its LIBOR index. For example, the one-month LIBOR rate is currently at about 1.60 percent. A margin for a monthly LIBOR mortgage might be 2.25 percent. Adding the 1.60 percent and the 2.25 percent would make a “fully adjusted” mortgage rate of 3.85 percent.

Herein lies one problem: You indicate that the interest rate is 3.75 percent. That makes perfect sense if your loan officer is offering you a margin of about 2.15 percent (1.60 index + 2.15 margin = 3.75 percent rate). Indeed, 3.75 percent sounds great, but I bet your rate can adjust every month.

If the rate goes up, your \$250 savings will diminish quickly.

A monthly LIBOR ARM with an interest-only payment option allows very low payments for two reasons. First, the interest rate is quite low. Second, an interest-only payment is lower than an amortized payment.

First, the low interest rate is adjustable, so it is not guaranteed.

Second, an interest-only payment does not diminish your principal balance.

As your loan officer pointed out, you can choose to make extra payments toward the principal balance.

This will indeed drop your balance as long as the rate stays low.

That’s the key.

Because the rate is adjustable, we don’t know for certain that the rate will stay low.

The other problem I have with the offer is that it will be expensive. One point equals 1 percent of the loan amount in cash.

Two points on a \$150,000 loan will total \$3,000.

Other closing costs such as appraisal, county recording fees, etc., could total an additional \$1,500.

So we’re looking at \$4,500 in sunk costs.

Here’s the bottom line: Does it make sense for you to pay off your 5.75 percent fixed-rate mortgage and exchange it for a monthly ARM that carries \$4,500 in fees with a start rate of 3.75 percent?

I think not.

As I said, I am a big fan of LIBOR-based mortgages.

The rates are rising, as they were expected to do, but they are still quite low.

An interest-only feature allows a borrower to use his funds for more practical purposes, rather than pay down a tax-deductible, low-interest mortgage.

This kind of program makes sense for certain people.

Having said that, a LIBOR is not for everyone.

If you are firmly planted in your house and already have a low fixed-rate mortgage, a LIBOR is not for you.

Stay put.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by

e-mail ([email protected]).