Fixed or flexible: Doing the mortgage math

After 15 rate hikes by the Federal Reserve, many economists are predicting the Fed is nearing the end of its tightening cycle. So, should prospective and current homeowners lock into the stability of a fixed-rate mortgage or remain flexible and favor adjustable-rate products?

“Yes. No. Maybe,” answers Joe Rogers, an executive vice president with Wells Fargo Mortgage in Columbia, Maryland. 

He is not being evasive. Given the number of mortgage products now available, the "right" answer depends on a borrower’s current budget, financial objectives and housing plans, more than the Fed’s moves.

Though rising interest rates have weakened demand for adjustable-rate mortgages (ARMs), it is not by as much as one might think. “[ARMs] share of all mortgage applications have declined from 35 percent to 27 percent,” says Douglas Duncan, chief economist for the Mortgage Bankers Association in Washington. Obviously, he adds, “a significant number of households still find ARMs useful.”

For instance, ARMs may be beneficial to borrowers planning to sell their homes within a few years by minimizing monthly payments through slightly lower rates than available on fixed-rate loans. For those whose loans are big enough, the refinancing costs may be more than offset by rolling annually from one low “teaser” ARM product to the next. But wider acceptance of interest-only loans is also a factor, according to Duncan.

Though interest-only loans often have fixed rates and behave similarly to a 30-year loan, they are classified as ARMs, because monthly principal payments are optional. They are becoming more popular because, says Duncan, payments effectively behave like tax-deductible rent allowing borrowers to direct would-be principal reduction amounts to other expenses or savings goals. Yet, unlike a rental, as the value of the mortgaged property increases, the borrower builds equity in the home. This is why interest-only products have been favored by higher net-worth types who already have significant home equity and, more recently, by those stretching to buy a home.

Keeping payments as low as possible for cash flow purposes and hoping home values continue their historical climb are the rationales behind all adjustable products, not just the interest-only loans, explains Duncan. From an investment prospective, using such leveraging maximizes the homeowners’ total return — assuming they bought well and home values rise — while freeing up monthly cash flow for other purposes.

But mimicking the leveraging strategies of sophisticated real estate investors introduces greater risk into borrowing. The risk that monthly payments will fluctuate upward with interest rates to a point where they become burdensome. That could soon be the case for those who took out ARM products in recent years and for those who took out home equity loans.

Such borrowing for maximum leverage or flexibility requires continually monitoring rates, predicting of where rates are headed and making comparisons among the growing number of mortgage products available to ensure the most advantageous one is being used for current conditions. It means actively managing debt the way one does assets, like a stock portfolio.

MORE FROM REAL ESTATE

Real estate Section Front

Housing construction hits a 7-month high Mortgage rates fall, inch toward record low Homebuilder sentiment highest since Sept. Foreclosures up 15 percent in first half of 2009 Mortgage demand rises for second week States sue over alleged loan modification fraud New home appraisal rules stir industry uproar Places you can actually get ahead in recession Defaults on commercial real estate accelerate Madoff’s former office looking for a tenant Real estate Section Front   Add Real estate headlines to your news reader: