- The Washington Times - Wednesday, July 19, 2006

Q:My fiance and I are in the market to buy our first home. We have been preapproved

for mortgage financing of up to $400,000 and have saved enough money for a 10 percent down payment.

We are not interested in any of the fancy low-payment programs that are being offered, but I think we should take out a 7/1 adjustable rate because I can’t possibly see us being in the property for more than about five years.

My father thinks we should take out a 30-year fixed-rate and play it safe.

What’s your opinion?

A: Welcome to Mortgage Financing 101. Your question is a great example of the kinds of things all home buyers should carefully examine.

The first thing to do is understand that choosing a fixed-rate loan is akin to taking out an insurance policy. A fixed rate protects you from future rate increases but will be more expensive than an adjustable rate mortgage (ARM).

Determining the probability of certain events, coupled with simple math can help you decide which mortgage product is best. So far you are on the right track.

If you think there is almost a 100 percent probability that you will either sell or refinance your property within seven years, there is very little reason to take out a 30-year fixed-rate loan.

Why would you purchase the “insurance” of a fixed rate for 30 years when you are only going to hold the loan for seven years?

Determining the probability of the holding period of the loan is the first step. It’s also important to evaluate your own risk tolerance. Some folks might declare that there’s a 95 percent chance of selling their property within five years, prompting them to take out a 5/1 ARM, where the rate is fixed for the first five years, and lower than a 30-year fixed loan.

But some of these folks are worried about the 5 percent chance that they will hold the property for more than five years, prompting them to take the more expensive, 30-year fixed-rate loan.

The second step in choosing the right mortgage program is to understand that everything has its price. This is where the simple math comes in. The difference, or spread, in the interest rate between a 7/1 ARM and a 30-year fixed rate will surely influence your decision on which product you choose.

If you are risk averse and prefer a 30-year fixed rate, even though you think there’s a high chance you will sell within seven years, how much lower must the 7/1 ARM be before you turn down the 30-year fixed rate?

If a 30-year rate is offered at 6.75 percent for example, and the 7/1 ARM is offered at 6 percent, the cost of the “insurance policy” of the 30-year program is only 3/4 percent. That’s a big spread. But if the seven-year program was only an 1/8- or 1/4-percent lower than the 30-year deal, you might stick with the fixed rate.

Let’s take a look at some real numbers.

Over the last couple of years, short-term rates have risen considerably, while long-term rates have risen only modestly. This has created what’s known as a “flattening” of the yield curve, which means that there isn’t a big spread between short-term rates and long-term rates.

Here’s a sampling of the rates as of this writing:

• 3/1 ARM = 6.375 percent.

• 5/1 ARM = 6.50 percent.

• 7/1 ARM = 6.50 percent.

• 10/1 ARM = 6.75 percent.

• 30-year fixed-rate = 6.625 percent.

The yield curve can’t get much flatter. A 30-year fixed rate is only 1/8 percent higher than a 5/1 or 7/1 ARM, and it’s actually lower than the 10/1 ARM.

What does this tell us? Well, it tells us that the “insurance policy” of a 30-year fixed rate is cheap. There’s usually a much bigger spread between a 5/1 ARM and a 30-year fixed rate.

Even though you plan on paying off the loan within seven years, to pay only 1/8 percent more to have the peace of mind of a fixed rate might not be a bad idea. Your father might be right.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail (henrysavagepmcmortgage.com).

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