Friday, January 9, 2009

With my fingers crossed, I see that mortgage rates have remained low since Thanksgiving. While the media has given a very inaccurate impression of a free fall, rates have remained low and stable to create refinance opportunities for homeowners who have adequate equity and good credit.

Over the last few weeks, I have refinanced many clients who had mortgages with an interest-only payment option. An interest-only loan allows the borrower to pay only the interest charged each month. The mortgage balance neither increases nor decreases. Interest-only loans gained popularity during the housing boom because they gave borrowers more purchasing power in an environment where housing prices were skyrocketing.

Much can be said about the integrity of these loans. Many consumer advocates charge that these loans contributed to the mortgage meltdown. My personal view is that choice, coupled with education and personal responsibility, is a good thing for American consumers.

Whatever your opinion about interest-only loans, I’d like to describe a scenario that demonstrates the benefits of switching to an amortized loan. A fellow purchased a home three years ago in Maryland. After discussing his objectives and reviewing the available products at the time, he decided to take a 7/1 adjustable-rate mortgage at 6.375 percent with an interest-only payment option and a 30 percent down payment.

I received a call from him recently to discuss refinancing. He still likes having a low payment with the interest-only loan and he tells me that his neighborhood has been spared from the home-value decline that has plagued so many other areas.

He hears that interest rates have dropped and, like millions of other homeowners, he wants to know if he can save some money by refinancing. The answer, in a nutshell, is yes and no. Thanks to the mortgage meltdown, rates on interest-only loans are still very high, so it’s not practical for my client to refinance to a new loan with an interest-only feature.

However, he can surely lower his interest rate if he takes out a standard fixed-rate loan amortized over 30 years. I quoted him an interest rate of 5.125 percent with no points and no origination fees. Closing costs — including appraisal, title insurance, county-recording fees, etc. — will total about $2,800. Although he drops his interest by 1.25 percent, his monthly payment actually increases by $150 because the loan balance is curtailed each month.

My client tells me that while he would prefer to keep his payment down, he understands that it may make sense to start paying off the loan. A $150 monthly increase is affordable. I then startle him with some simple number crunching.

I pull up my amortization schedule and plug in a new loan balance that includes the $2,800 closing costs with a 30-year amortization at 5.125 percent. Numbers don’t lie. Here are a couple of observations:

The loan balance falls by $2,800 by the fourth mortgage payment. In other words, it only takes four months to recoup the closing costs.

The mortgage balance drops by $12,000 by the 24th month. This means that 24 payments of an additional $150 per month (or $3,600) results in a principal curtailment of $12,000, resulting in a net reduction of $8,400 over a two-year period.

This scenario illustrates the beauty of low interest rates. For folks who have an interest-only loan, it’s certainly worthwhile to see if refinancing to an amortized loan with a lower rate makes sense (even if the payment increases). Please heed my mantra: Watch the fees. It’s better to take a rate that’s slightly higher with no points and little or no closing costs than to get suckered into a seemingly low rate that costs multiple thousands in nonrefundable fees.

Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail at

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