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Financial Planning: A Midyear Guide 1987 : part four: Borrowing : Negotiating the Maze of Mortgage Options

June 21, 1987|DAVID W. MYERS | David W. Myers writes about real estate for The Times

Martin Zweben and his wife, Christina, say finding their dream home in Palos Verdes was easy. When the couple saw the handsome ranch-style house and its views of the Pacific, Zweben said, "we fell in love with it instantly."

But deciding how to finance their purchase wasn't nearly as simple. "I couldn't believe how many different kinds of mortgages there are today," said Zweben, a public relations executive in Santa Monica. "Fixed-rate loans, adjustables, loans you don't even have to qualify for--it's enough to drive you nuts."

Indeed, the wide variety of mortgages today makes choosing the one that's right for you a difficult task. The recent upturn in interest rates hasn't helped matters; thousands of home buyers who had planned on getting a fixed-rate loan can no longer qualify because rates have jumped to about 11% today from less than 9% in March.

Some financial experts say the rate run-up has given adjustable-rate mortgages new luster. Many lenders still offer ARMs with introductory rates as low as 7.5% and with caps that prevent them from rising more than five percentage points over the life of the loan.

"If you can get a 7.5% adjustable with a five-point cap, it'll never go above 12.5%," says Knight A. Kiplinger, editor-in-chief of Changing Times magazine. "And 12.5% isn't much higher than the fixed-rate loans some lenders are offering today."

ARM rates are adjusted periodically based on changes in a given index. In California, the most popular index is the 11th District cost of funds, a composite figure that reflects rates the Federal Home Loan Bank charges lenders for a variety of different loans. Other popular ARMs are linked to the more volatile rate of one-year Treasury securities. Still others are pegged to longer-term Treasuries, the prime rate, or more obscure indexes.

If you think interest rates will head south again--and many economists believe that they will--you'll want to select an ARM linked to one-year Treasuries because the index reacts more quickly to interest-rate swings. But if you can't stomach the volatility or fear that rates will move higher, pick an ARM that's wed to the slower-moving cost-of-funds index or five-year Treasury index.

All lenders slap on a markup, or "spread," on the index once the introductory period has ended. If the index rate is 8% and the lender's spread is two percentage points, your new interest rate will be 10%. If a lender wants a spread larger than 2 1/2 points, it's best to look elsewhere.

In addition to insisting on an ARM that can't rise more than five or six points over the life of the loan, it's also important to have a cap on how much your rate can rise each time it's adjusted. John Cahill, co-owner of the San Francisco-based financial planning firm Carroll/Cahill Associates, says you should shun any loan that can rise more than two points each time it changes. "You could eventually find yourself in a real 'cash crunch' if the limit is any higher," he says.

ARMs often attract first-time home buyers because their low initial rates make it easier to qualify for a loan, Cahill says. Even if you're not a first-time buyer but plan on moving again relatively soon, an adjustable with a low introductory rate that won't be changed for two or three years is a better choice than a fixed-rate mortgage because you'll probably be gone before the rate can ratchet upward, he adds.

Of course, you won't want an adjustable loan if you can't sleep at night knowing that your monthly mortgage payment is subject to change. But even if you opt for a fixed-rate loan, you'll have to choose from a variety of products.

Fixed-rate, 30-year mortgages: These loans are most popular when interest rates are low because borrowers want to "lock in" the attractive rate and like the idea of knowing their payments won't change. They also require the lowest monthly outlays because you have 30 years to pay the money back.

On the downside, a 30-year repayment plan means it'll take longer to build equity in your home, and interest payments over the life of the loan will be far higher than if you picked a shorter-term mortgage. You'll also regret having a fixed-rate loan when mortgage rates are dropping, because the only way you can take advantage of the decline is by spending a lot of money to refinance.

Fixed-rate, 15-year mortgages: These loans have several advantages over their 30-year counterparts. Your overall interest payments will be cut by more than 50% because the repayment period is shorter and rates on 15-year mortgages are a shade below those on 30-year loans.

Even better, you'll own your home free and clear in half the usual time. "Fifteen-year mortgages can be ideal if you want to pay your home off before you retire, or before your kids trot off to college," says Ira Cohen, senior vice president at ARCS Mortgage Inc. in Canoga Park.

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