Mortgage rates stabilize, buyers pull back
By Holden Lewis • Bankrate.com

Mortgage rates stayed flat amid signs that consumers are becoming more selective about their spending.

The benchmark 30-year fixed-rate mortgage stayed the same at 6.35 percent, according to the Bankrate.com national survey of large lenders. A basis point is one-hundredth of 1 percentage point. The mortgages in this week's survey had an average total of 0.39 discount and origination points. One year ago, the mortgage index was 5.39 percent.

The 15-year fixed-rate mortgage fell 3 basis points to 5.71 percent. The one-year adjustable-rate mortgage fell 1 basis point to 4.11 percent.

Consumer confidence in May budged upward less than had been expected, orders on durable goods were down 2.9 percent in April and sales of new homes fell in April. Mortgage rates stayed flat or eased slightly along with those latter indicators.

The stabilization in mortgage rates comes as a relief to borrowers after eight straight weeks of rising rates. Even though it looks like mortgage rates are on an upward trend overall, adjustable-rate mortgages, or ARMs, are becoming popular. More than one third of borrowers are taking them. At least initially, ARMs have lower rates than fixed-rate loans, and the monthly savings account for their appeal. Many mortgage bankers insist that even more people would get ARMs if they understood them better.

"Do the math," says Larry Goldstone, head of Thornburg Mortgage, a lender that specializes in ARMs. "I think what's important here is the importance of doing the math, because I think that people tend to draw the wrong conclusion. They let intuition drive their decision process without doing their homework."

Intuition can be wrong
Intuition tells people that adjustable-rate mortgages are risky and volatile and that borrowers "are going to feel sorry they took those kinds of loans," Goldstone says. But he points out that the rates for the ARMs that are considered the riskiest -- those that adjust every month or six months -- are about three percentage points lower than those for 30-year fixed-rate mortgages. Those ARM rates might or might not go up sharply in the future, but they certainly are low now.

"In the meantime, you're saving money every month on your mortgage payment," Goldstone says.

The smart thing to do is to use a mortgage calculator or spreadsheet program to run various interest rate scenarios. "These calculations aren't being done," Goldstone says in a phone interview, with frustration evident in his voice.

For example, consider a $200,000 loan. You're weighing a 30-year fixed loan at 6.5 percent vs. a 5/1 hybrid ARM at 5.38 percent. The 5/1 ARM keeps that 5.38 percent rate for the first five years, then adjusts annually after that. The rate can go up a maximum 2 percentage points a year, and up a total of 6 percentage points lifetime. That's the worst-case scenario. Assume it happens and run the math.

OK, let's do the math
Monthly principal and interest payments on the 30-year fixed are $1,264.14. Monthly payments on the 5/1 ARM are $1,120.57 -- a saving of $143.57 a month.

Multiply those amounts by 60 months, or five years. The 30-year fixed mortgage costs $75,848.40 over that time. The 5/1 ARM costs $67,234.20, or $8,614.20 less over five years.

Let's say the 5/1 ARM rate jumps to 7.38 percent in the sixth year, the highest it could go up in one year. The monthly principal and interest payment would rise to $1,382.03. At that point the monthly payment is $117.89 higher than for the 30-year fixed, for a total of $1,414.68 more during the sixth year.

The $8,614.20 savings in the first five years, minus the $1,414.68 higher cost in the sixth year, means that after six years, the ARM has cost $7,199.52 less than the fixed-rate loan.

If the ARM rate jumps another 2 percentage points in the seventh year, to 9.38 percent, principal and interest payments are $1,664.23 a month, or $400.09 more than the 30-year fixed. The ARM costs $4,801.08 more in the seventh year, but still, after seven years, the ARM borrower has saved $2,398.44.

If the ARM rate jumps to its lifetime cap of 11.38 percent in the eighth year, the monthly principal and interest rise to $1,962.29 a month, or $698.15 more than the 30-year fixed. The break-even point, when the cumulative payments on the ARM exceed the total payments on the fixed-rate mortgage, comes after seven years and three months.

The way Goldstone and other lenders look at it, the worst-case scenario is unlikely to happen and, anyway, you probably will move before the monthly payments get out of hand. Half of homeowners sell their homes and move within about eight years. If you think you will move within five or six years, it's a good idea to compare a fixed rate with ARMs.

If you are pretty sure that you will remain in the house for 10 years or more, a fixed rate is probably your best bet. And if you're not confident that you could handle the payments if the interest rate rose 3 or 4 percentage points in a few years, you should stick with a fixed-rate mortgage.

Don't get an ARM for frivolous reasons, Goldstone cautions: "Instead of taking the savings and spending it on vacations and automobiles, maybe you ought to spend it on extra principal and build equity," he says. It sounds less like a suggestion and more like a command.