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Despite fixed-rate fad, it may be best to bear ARMs

Adjustable-rate loans, especially those with an interest-only component, recently have been shunned and criticized, hammered and nailed. If you are looking for sympathy in your daily life, simply mention at your kid’s weekend basketball game that you have an ARM set to adjust in May.

Ever since the mortgage mess began to unravel, consumers have raced to fixed-rate loans, reportedly with a newly found “pay-it-off” mindset. While this appears to be great news, it does not ensure that these same folks will not dip into their home’s equity when the housing market eventually returns. That sort of discipline has yet to be proven among the baby boomers that have shown a tendency to refinance, or take out a home-equity loan, for cars, vacations or a hot stock tip.

In reality, refinancing to a 30-year, fixed-rate loan may not be the best strategy for a homeowner looking for lower payments while hoping to reduce the principal.

For example, let’s assume a working couple has a five-year, interest-only ARM with an interest rate of 6 percent. When an ARM adjusts, the index and margin are added to arrive at the new interest rate. The index for the loan (the financial gauge which determines the loan’s interest after it adjusts) is the one-year LIBOR, around 2.12 now. The margin (the amount added to the index to ensure a lender’s profit and cover costs) is 2.25. Combine the two numbers and the couple’s new interest rate is 4.37, lower than their initial interest rate. The couple could take the amount saved each month and apply it to the loan’s principal, thereby creating a fully amortized loan.

Tom Lasswell, loan adviser, clarifies that allowing an ARM to adjust may be the best avenue for borrowers – especially if they are only going to remain in the home for a short period of time. According to Lasswell, borrowers too often are swayed by the “flavor-of-the-month” loan, which may or may not be the best loan for them.

And many consumers are also unaware that they can make extra principal payments every month on their interest-only loan. Most borrowers, even those with significant prepayment penalties, can make lump-sum payments to their principal balance as long as the lump sum is not greater than 20 percent of the current mortgage balance. For example, if a borrower had a $300,000 loan with a prepayment penalty, most of the time the borrower could pay $60,000 directly toward principal without triggering the penalty.

In a recent column, we discussed the case of a young woman with excellent credit and a decent job who bought a home four years ago. She was dinged with a new “risked-based” premium when she attempted to refinance due to a late credit-card payment from her previous job.

Why not just let her ARM adjust, make the new payment after the adjustment, and then refinance to a fixed-rate loan when her credit issues were resolved? The gamble would be the possibility of higher fixed-rate loan environment down the road. Rates now are at historic lows, and loan officers and some in the news media have been eager to promote the benefits of fully amortizing loans rather than the “just renting” element attached to interest-only mortgages.

Let’s look at the young woman’s situation again from a different angle:

After four years of perfect mortgage payments plus a move to a better job, the woman began the process to refinance to a fixed-rate loan. To her surprise, her credit scores had dropped considerably, due to a late credit-card payment. While her name was on the card, it was for company business (custom printing, copying) and not her personal use. Before the card was transferred to her successor, a payment was missed.

After the missed payment, the woman’s credit scores from the three bureaus were 696, 706 and 756. Since most lenders take the middle score when it comes to mortgage qualifying, she was assigned a score of 706 on her loan documents, which then cost her an additional $2,364.38. Here’s why:

A 706 credit score had a “risk-based” mark-up of 0.75 points based on her estimated home value of $420,000. (If the value had appraised at $425,000 or more, the add-on would have been only 0.50 because her loan-to-value would have been below 75 percent). If the middle credit score was 740 or higher, there would be no add-on at all.

If the woman added the risked-base markup ($2,364) to the 1.675 loan fee ($7,035) the total ($9,399) would equal an amount slightly greater than the first two years’ of the principal portion ($9,233) on a $420,000 fixed-rate loan at 6 percent.

If you are considering a refinance from an ARM to a fixed-rate loan, first ask yourself how long you see yourself staying in the home. It could be worthwhile to take all the fees you would pay for a refinance and pay down your present principal. If you have credit issues that need to work out to avoid paying higher fees, it may be worth staying put until your credit is repaired.

Tom Kelly is a former real estate editor for the Seattle Times. His book “Cashing In on a Second Home in Mexico: How to Buy, Rent and Profit from Property South of the Border” was written with Mitch Creekmore of Stewart International.