Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Taking on rate risk can shorten mortgage length

Dear Dr. Don,
We are buying what we hope will be our last house. The mortgage is for $80,000, while the house is worth $185,000. My question is, what would be in your opinion the best bet? My choices are a 30-year fixed-rate mortgage at 5.5 percent, a 30-year variable-rate mortgage currently at 5 percent, or an interest-only LIBOR mortgage at 3 percent but the interest rate can change every six months. I would pay about $1,200/month with $1,000 going to principal because I would try to pay the house off in about five to six years.
Thanks,

Steve Shorten

Dear Steve,
Being willing to take on some interest rate risk can shorten the life of your loan and potentially reduce the amount of interest paid over the life of the loan. The table below uses the information provided in your letter with the simplifying assumption that the interest rate on the variable rate loans stayed constant over the life of the loan.

The Federal Reserve establishes the targeted rate for Fed Funds and that rate influences other short-term interest rates. LIBOR is the British equivalent of the Fed Funds rate.

The Fed is trying to stay on the sidelines for now to encourage economic growth by taking away the threat of rising short-term interest rates. That gives variable-rate mortgages a short-term advantage over fixed-rate mortgages. LIBOR doesn't have to move in tandem with the Fed Funds rate but the two rates are highly correlated.

Your aggressive approach to making additional principal payments makes the interest-only mortgage a viable option. While you are taking on the interest rate risk, the large additional principal payments diminish the amount of money at risk as time passes. I did run a what-if scenario that had the interest rate on your interest-only mortgage go up by 1 percent each year and the loan was still paid off in 78 months with a total interest expense of $12,625.85.

Regardless of the mortgage you choose, make sure the lender allows additional principal payments without a prepayment penalty. A prepayment penalty in the early years of the mortgage takes away the current short-term advantage of using variable-rate financing.

If you know the loan's pricing spread to LIBOR and which LIBOR rate is being used you can use Bankrate's Rate Watch page to monitor changes in the mortgage interest rate.

In the end you need to ask yourself, "How much risk am I willing to take on to save a few thousand dollars over the interest expense on the fixed-rate loan?" To me, the ARM at a current interest rate of 5 percent with a 30-year amortization doesn't offer enough of an incentive to take on the interest rate risk, but the interest-only LIBOR-based ARM does. With that loan you have the potential to cut your interest expense in half on either a pretax or after-tax basis.

-- Posted: Oct. 14, 2003