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YOUR MORTGAGE : Looking at the Pluses and Minuses of Shorter-Term Loans

September 12, 1999|KENNETH R. HARNEY | SPECIAL TO THE TIMES

WASHINGTON — Faced with mortgage rates at 8%, home buyers are rediscovering a type of loan that's been out of favor for most of this decade: short- and intermediate-term mortgages that cut the fixed rate by anywhere from a half to a full percentage point.

Mortgage companies and large investors like Freddie Mac report that three-year, five-year and seven-year loans--all with optional features converting to 30-year financing--have suddenly begun pulling in rate-sensitive buyers and refinancers.

The national financial reporting service HSH Associates, which surveys more than 2,500 lenders, found that last month five-year hybrid loans carried average rates of 7.38% nationwide compared with 30-year conventional mortgage rates averaging 8.01%.

The same survey found seven-year hybrid loans carrying average rates of 7.45%.

Freddie Mac, the biggest national investor in five-year balloon fixed-rate mortgages, said rates were about 7.5%--an attractive discount from 30-year competitors.

What are short-term hybrid and balloon mortgages and who can they help most? What sort of consumer snares do they entail? Here's a quick overview of a potentially valuable resource for buyers and refinancers seeking cheaper money:

At first glance, loans with three- and five-year terms appear a little scary. After all, who wants to have to pay back a home mortgage after just 36 or 60 months? But virtually all of these loan offerings come with term-lengthening features.

There are two major categories for borrowers to be aware of: first, hybrid mortgages. They're called hybrids because they represent creative blends of fixed-rate and adjustable-rate loans.

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Hybrid Loan Fixes Rate for Three Years

A three-year hybrid, sometimes also called a "3-1" or a "3-27," carries a fixed rate for the first three years, then converts into a one-year adjustable for as long as 27 years. A five-year hybrid carries a rate that is fixed for the first five years, and turns into an adjustable for up to 25 years.

The shorter the fixed-rate portion of a hybrid, the steeper the discount off 30-year rates. Hence, a three-year hybrid last month could be found in most markets for about 7%, whereas a five-year hybrid was close to 7.4%.

Both quotes carried roughly one point--1% of the loan amount--in origination fees.

Paul Skeens, senior loan officer for Carteret Mortgage Corp. in Fort Washington, Md., said he particularly recommends three- and five-year hybrids to clients needing mortgages of more than $240,000, beyond the purchase limits of Freddie Mac or Fannie Mae.

That's because in the hybrid field, these jumbo loans don't necessarily carry higher rates than smaller loans, as they do in the conventional fixed-rate market.

Skeens said the five-year hybrids "are really excellent choices" in the current rate environment because borrowers not only get a cut-rate loan but also have the opportunity to refinance any time in the next five years without penalty, before the loan converts into a one-year adjustable.

There are some notable downsides to hybrids as well. For starters, when they convert to adjustable, they subject the borrower to rates potentially far higher than 7% or 7.5%.

If inflation reared its ugly head and short-term rates hit the levels of the early 1980s, borrowers could be paying as much as 13% on the hybrid mortgage they signed up for at 7%.

That's not likely, but it's possible. And that's why hybrids are best for people who expect either to move or to refinance within the fixed-rate time period of the loan. They get all the benefits of a discounted fixed rate but none of the worries of a one-year adjustable.

What about balloons?

They, too, carry five- or seven-year terms with rate discounts. But unlike hybrids, they carry definite termination dates with an optional, one-time-only rate reset.

Say a borrower takes out a five-year balloon in September at 7.5%. Sixty months from closing, he or she will have the option of either paying off the note by refinancing into a new loan or going for a reset rate--determined by the lender--that would be fixed for up to 25 years.

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Can Be Reset at Current Rate

If rates fell below 7.5%, the borrower could reset for 7% or 6.5% or whatever the lender's current reset rate was. Unlike a refinancing, there would be virtually no transaction or closing costs to reset the rate.

If rates had risen during the five years, the borrower could compare the reset rate to prevailing market rates and decide whether to pay off the balloon or continue.

The bottom line here: Borrowers should check out shorter-term loan options if they're looking for a discounted fixed rate. But they should make sure the loan officer or advisor discusses all the potential downside scenarios of the options.

Distributed by the Washington Post Writers Group.

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