Updated: May 3, 2013 12:14PM
Originally published: August 7, 2001
The stock market is finally paying attention to the Fed--and so should you if you’re thinking about getting a home mortgage.
Although the Federal Reserve Board has been focused exclusively on ratcheting up short-term interest rates, almost all other rates are climbing, too.
On a 30-year fixed-rate mortgage, currently averaging about 8 3/8 percent in the Chicago area, a one-half percentage point increase in the mortgage interest rate translates into $12,600 in additional interest payments over the life of a $100,000 loan.
Of more immediate importance, it translates into an increase of $35 in every monthly payment. (At 7 7/8 percent, the monthly payment of principal and interest is $725. At 8 3/8 percent, the monthly payment becomes $760.) And that difference could price many buyers out of the market.
Of course, the Fed announced that its intention in raising rates is to slow the booming economy, and if that means pricing some families out of the home market, the Fed says that’s the price to pay.
But if you’re shopping for a mortgage, a bit of creativity may help you get around the Fed’s rather arbitrary position on economic growth. The advent of online mortgage shopping and new creative financing, as well as automated underwriting by lenders, means people are less directly affected by the Fed’s actions. And lenders have become more liberal in their underwriting practices.
So it’s worth checking with lenders to see if you can be pre-approved for a specific size loan before you go house shopping. After all, higher mortgage rates may hold down the recent increase in home prices.
If you just can’t stand the idea of higher interest rates, you could take a 15-year fixed-rate mortgage, and probably pay only 8 percent. But because of the shorter time period to pay that loan, the mortgage payment would be $955 compared with $760 on the 30-year loan.
That helps you beat the Fed’s interest rate effect by saving $101,608 in interest over the life of the loan--but it certainly doesn’t make the home more affordable.
But don’t despair. There are new adjustable rate mortgages that are very attractive in some cases. Consider a 30-year loan with a five year fixed-rate component, and market adjustments after that point. You lock in a current rate of around 8 percent--three-eighths of a percent lower than a standard 30-year loan. Because your payments are based on a 30-year repayment schedule, this loan would cost about $734 a month per $100,000 borrowed.
You get the lower rate and lower payment because you’re taking some of the interest rate risk, instead of letting the lender assume all the risk. And the $375 you save in interest each year could more than pay for the cost of refinancing if rates do move lower.
To be comfortable with a 5-year adjustable rate loan, you have to believe that you’ll sell the house within the 5-year lockup period, or that you’ll be able to refinance sometime during that period at a lower rate.
Randy Johnson, author of the best-selling How to Save Thousands of Dollars on Your Home Mortgage (Wiley, 1998) says: “Over the last 20 years, the market has tended to reward people who were willing to take a little risk with their mortgage. Conversely, those who sought maximum protection tended to pay for rate protection they did not need.”
Whether or not you’re willing to take the risk on an adjustable rate mortgage depends on your own personal situation--and your evaluation of the economic outlook. Even though many consumers have vivid memories of runaway inflation and sky-high interest rates from the early 1980s, it certainly appears that the Fed has learned its lesson and will nip inflation in the bud. Thus, it’s more reasonable to assume you’ll have a chance to refinance at lower rates sometime in the next five years.
On the other hand, if you’re living on a fixed income or just can’t stand uncertainty, it may pay to lock up today’s 8 3/8 percent rate for 30 years--as long as you know the price you’re paying for peace of mind.
And that’s the Savage Truth.
Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Devon Energy Corp. You can send questions to her via e-mail at firstname.lastname@example.org. Her third book, The Savage Truth on Money, was recently published by John Wiley & Sons Inc.