By Joe Catalano

February 20, 2004
Predicting the movement of mortgage rates these days has become a bit like guessing the path of a leaf fluttering in the wind. Every time rates climb higher -- and appear headed on an upward path -- they suddenly dip again.

Rates for 30-year fixed mortgages bottomed out at 5.21 percent in mid-June, went as high as 6.5 percent in August and then have fluttered up and down, dropping to 5.66 percent recently, the lowest rate in six months, according to Freddie Mac, the No. 2 purchaser of U.S. mortgages, which tracks rates each week.

Still, the overall trend is up and is likely to continue so as the economy recovers, most economists say. Many experts see rates hovering around 6.5 percent again by year's end.

Aware that rising rates are putting an end to the refinancing boom -- which accounted for 75 percent of the mortgage industry's business in recent years -- more lenders have reshifted their focus to home purchase loans, said Keith Gumbinger, vice president of HSH Associates, a mortgage research firm in Pompton Plains, N.J.

Lenders are also betting that as home prices continue to climb -- albeit slower than in the past two years -- more buyers won't be able to afford a house using traditional 30-year fixed mortgages, since salaries have not kept pace with price increases.

As a result, many lenders are now heavily marketing a new crop of mortgages that offer alternatives to consumers: They can be used to buy less expensive houses should rates continue to rise -- or more expensive homes should rates stay the same, Gumbinger said. Even first-time buyers can use these products, which include interest-only mortgages, negative amortization loans and hybrids that combine fixed and adjustable mortgages. In most cases, the borrower qualifies for the loan at the lower starting payment.

But while these loans may allow more people to become homeowners, experts warn they should be approached with caution.

Many are "a cause for disaster," said Jason M. Morley, president of Morley Financial Planning in Bohemia. In such cases, borrowers start with a lower monthly payment than with a 30-year fixed loan, but payments rise after several years to more than they may be able to afford, Morley said. Some loans also defer paying principal, leaving owners with no equity except what they gain from the home's appreciation in value.

Ideally, when the monthly payment is lower, borrowers should save or invest the extra cash for when the payment rises -- but that seldom happens, Morley said.

To prepare for the shifting mortgage landscape, here are strategies -- and some specific alternatives to traditional fixed loans -- that can be used whichever way interest rates go.

Strategies

Shop, Shop, Shop Around. Loan products and rates do differ among lenders, so do your homework. For example, rates for jumbo loans -- those greater than $333,700 -- are usually 1/4 percent higher than rates for mortgages up to that amount, known as conforming loans. But some lenders charge the same for jumbos up to various amounts depending on the investors purchasing their loans, said Mark Pappas, president of IPI Skyscraper Mortgage, a division of Mortgage IT in Manhattan. For example, Mortgage IT charges the same for jumbos up to $1 million.

Increase the Down Payment. Suppose, for example, that you plan to buy a home for $400,000 with 20 percent down. If the interest rate were 5.5 percent, the monthly principal and interest payment would be about $1,817. But say rates rise to 6 percent, said Elisa Nahoum, president of Na-Home Funding Corp., a Whitestone mortgage broker. Increase the down payment to 25 percent, or $100,000 and the monthly payment is still $1,798.

Pay Points to Lower the Rate. For every point paid (one point equals 1 percent of the loan amount), the rate drops 1/8 percent to 1/4 percent depending on the loan, Gumbinger said. For example, if you pay 2 points, or $6,000, on a $300,000 loan, a 6 percent rate drops to 5.5 percent. The monthly payment is reduced by about $95 with the break-even point coming just after five years.

One variation is the "2/1 buy-down," said Jonathan Pinard, president of National Residential Mortgage Banking Corp. in Hauppauge. Say, for example, you have a 30-year 2/1 buy-down loan at 6 percent interest. If you paid 3 points upfront, the rate starts 2 points lower, at 4 percent, rising a point each year until it hits where the loan will be for the rest of the term -- in this case 6 percent.

Each monthly payment is based on the loan's interest rate for that year. This is good for newly minted professionals, who need a lower starting payment as they build their practice, Pinard said.

Alternative Loans

Adjustable Rate Mortgage. These loans, known as ARMS, often start with a fixed period of three, five or 10 years, said John Monaco, senior loan consultant for Fleet Mortgage's West Hempstead office. The shorter the fixed period, the lower the initial rate and monthly payment versus a 30-year fixed loan.

Typically, a 10-year ARM is 1/2 percent lower than a 30-year fixed, said Chris Bartlett, a mortgage broker with the Home Mortgage Acceptance Corp. in Manhattan. A five-year ARM is 1 percent to 1.5 percent less, and a three-year is 1.5 percent to 2 percent less. The downside is your payment increases if rates rise after the fixed period ends.

These are best for people who know how long they'll stay in a house, Morley said. If planned correctly, they move before the rate adjusts.

40-Year Mortgage. By stretching the term, the monthly payment is lower, Pappas said. For example, on a $320,000 loan, the monthly payment on a 30-year at 5.5 percent is $1,817, vs. $1,651 for a 40-year, a difference of $166.

The drawback is more interest is paid if the loan is held full-term. On a $200,000 loan at 5.75 percent, the difference in the monthly payment is $102 less than on a 30-year loan, but $91,400 more interest is paid over the loan's life.

On the other hand, lenders say most people move or refinance before the term is over.

Interest-Only Loan. These loans have become a very popular product, said Shawn D. Cassidy, area manager for Wells Fargo Home Mortgage Inc. in Garden City. The rate is fixed for the first three, five, seven or 10 years, with the monthly payment consisting of interest only. After the fixed period, the loan turns into an adjustable loan (although fixed variations exist at some lenders). Monthly amounts are higher, because they switch to principal and interest payments for the loan's duration, with the rate adjusted yearly, he said.

But the rate can be even higher if rates have risen during the fixed period, Gumbinger said. You are gambling that your income will increase and your home will appreciate, since you're not building equity when you just pay interest.

However, principal can be paid at any point, with monthly payments then based on the lower principal amount, Bartlett said. This lowers future payments -- in contrast to fixed loans, where paying extra principal only decreases the loan's term, not the total monthly payment. This loan is for those who plan to sell or refinance before the fixed portion ends, he said.

Those who keep the loan longer usually pay down principal whenever their rate adjusts upward to keep payments from rising, said Fleet's Monaco.

Some loans, however, remain fixed after the interest-only period ends.

Na-Home Funding works with a lender that offers the "12 Mat Program." The 30-year loan recently started at 1.25 percent. For each of the next four years, the rate increases 1 percent until, in this case, it reached 5.25 percent in the fifth year. Monthly payments are interest-only, Nahoum said. At the start of the sixth year, the bank takes the 12-month Treasury bill average plus the margin the borrower qualified for (from two to three percent) and comes up with the fixed rate for the remaining 25 years. Recently, that rate was 3.44 percent. But if rates had risen, the fixed portion would have been higher, she said.

In another variation at Wells Fargo, the loan never amortizes. The 10-year interest-only loan of up to $3 million adjusts monthly, Cassidy said. At the end of the 10th year, it must be paid in full or refinanced.

Hybrid or Piggyback Loans. A first and second mortgage are taken out simultaneously. Various loan combinations are used, including a three-, five- or 10-year ARM with a home equity line of credit, or HELOC, Bartlett said. The latter adjusts monthly with interest-only payments. Lenders usually pay the HELOC closing costs and allow it to be paid down. But if it's paid off completely within three years, closing costs must be repaid, he said.

Example: Suppose you're buying a $400,000 house, with a 20 percent down payment and a hybrid mortgage of $320,000. This hybrid could include a first loan, for 70 percent of the total price or $280,000, at a 30-year fixed rate of 5.5 percent. The HELOC would be for 10 percent of the price, or $40,000. The monthly payment for the fixed loan would be $1,590 and the HELOC payment would be at the prime rate (4 percent), or $133. Thus, the combined monthly payment would $1,723 vs. $1,817 for a traditional $320,000 mortgage with 30-year 5.5 percent fixed rate.

Bartlett, who lectures to consumers on lending and answers questions at Themortgagegeek.com, said this loan is for people who want a more expensive home now and are expecting a bonus so they can pay off the HELOC.

These loans also can be done for jumbos with less than 20 percent down, said Art Saitta, vice president and area manager for Homestar Mortgage Services, a Syosset mortgage banker.

Take, for example, a $450,000 loan after you put 5 percent down. Suppose the first loan is a 30-year fixed mortgage for $300,000, Saitta said. At 5.75 percent the monthly payment would be $1,750.72. Say the second mortgage, for $150,000, is a HELOC, at 1 percent below prime or 3 percent for the first six months. The monthly payment would be $831.90 for a combined monthly payment of $2,582.62.

If the same $450,000 loan is taken as a 30-year fixed jumbo, the rate would be 6 percent with a monthly payment of $2,697.98, Saitta said.

By using the piggyback, you save the 1/4 percent jumbo premium, because the first loan is $300,000, within conforming rate guidelines, Saitta said. The combined piggyback payment is $115.66 a month less than the 30-year fixed jumbo. In addition, you don't pay $370 month in private mortgage insurance, or PMI -- required by lenders when less than 20 percent is put down.

Negative Amortization Loan. These are typically 30-year ARMS that adjust monthly and start about 1.5 percent less than 30-year fixed mortgages. (The term "negative amortization" means the principal increases, rather than decreases, during the term of the loan because you're not paying total principal due each month.) If the monthly payment is, say, $1,800 on a $300,000 loan at 6 percent, you may pay only $1,500. The remaining $300 is tacked onto the principal owed. There is usually a cap -- typically 10 percent -- of how much beyond the original borrowed principal you can go, he said. So when the principal, in this example, hits $330,000, it switches to an amortizing loan with payments based on what's owed at the then current interest rate.

"These look like great loans today but can hurt in the future," Pinard said. No equity is built at the outset, and if you have to sell early on, it may cost you money. But, he adds, the loan could be right for someone who wants low initial payments and is expecting a large bonus to pay down principal.