Is Your Adjustable Rate Mortgage Still The Right Choice (Part 2)?

Last month, we looked at factors driving rate markets to help you determine if an adjustable rate mortgage (ARM) was the right choice for you. This month, we’re revisiting the topic since so much has happened in the markets. Our goal is to give you information to help you make financial decisions about property you own or property you’re planning to buy.

We’ll begin by taking a look at the markets in a post-Katrina context. Then we’ll talk about what this means when you’re evaluating your primary mortgage. Finally, if you have a second mortgage or are considering one, we’ll explain why choosing the right second mortgage has become more important than ever.

Katrina’s Impact On Financial Markets
For six weeks before Hurricane Katrina struck, rates were on a steady climb. The economy was improving. And when this happens, the job of the Fed is to make sure growth doesn’t go too fast and cause price inflation to creep into the economy. So, at that time, they had been steadily hiking rates to slow the money supply and manage growth.

But when the storm crushed the Gulf Coast in late-August, investors rushed into the safety of bond investments. This is good for rates because bond yields (rates) and prices have an inverse relationship: when there’s a bond buying rally, prices go up and rates go down.

With the extensive damage, market experts initially predicted longer-term economic weakness. But something else was happening. Energy prices were soaring because of the damage to a region which has such a large hand in energy-production.

On the one hand, Katrina displaced thousands of workers and slowed the Gulf area economy (worth $40 billion in New Orleans alone) to a halt. On the other hand, high energy prices and abundant spending on rebuilding have once again fanned the flames of inflation.

So much in fact, that the Fed’s rate hike campaign is still in high gear, and many market experts are saying rates may continue on their current upward for the remainder of 2005.

What This Means For Your First Mortgage
This news has spawned a new wave of headlines targeted at ARM loan holders. As you hear all this press chatter, remember what we told you last month: choose your loan term according to how long you think you will be in the home.

If you won’t be in the home for 30 years, why pay a rate premium to get a loan that is fixed for 30 years? You’re better off going with a lower rate loan that’s fixed for however long you plan to be in the home. Then you can apply what you’re saving in interest toward paying down the loan balance.

You also may be hearing a lot of warnings about interest-only loans. But there are a couple of features of interest-only loans that the press rarely mentions. First, an interest-only option on a loan is exactly that: an option. You can choose to pay what ever you want from month to month. As an example, if you got a 10 year interest-only ARM for $500,000, you could pay the $2600 interest-only payment; pay the $3000 principal plus interest payment, or pay any amount above $3000 that you want.

Second, a not-so-well-known feature of interest-only loans is that if you pay down your loan balance, most lenders will re-calculate your payment at the new, lower balance. So in the example above, if you made your $3000 payment, your next payment would be based on a loan balance that was $400 less. This can add up – and lower your payment significantly – over time. Also, this is a great tool for those whose income includes periodic bonuses. It means you can pay your interest-only payment most months, then apply your bonus toward paying down principal, which lowers your payment.

The Shift Into Fixed Rate 2nd Mortgages
This is exactly how a Home Equity Line of Credit (HELOC) second mortgage works. And this is why HELOCs have been so popular as second mortgages in recent years. But the difference is that the rate on a HELOC can change on a monthly basis because it is based on the Prime Rate.

In June of 2004, Prime was at 4%. At that low point, and even as Prime has risen on pace with the Fed Funds Rate since then, there was no way a fixed-rate second mortgage could even come close. So the obvious choice for a second mortgage was a HELOC.

But now, Prime is at 7%. Which means that the rate is equal to or higher than a fixed rate second mortgage. So with respect to rates, the obvious choice for a second mortgage has shifted to the fixed rate programs. It’s important to note, however, that payments on fixed rate second mortgages will be based on the original principal balance.