Weigh costs before buying down loan

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Dear Dr. Don,
I have a $598,000, 6.15 percent, 30-year, interest-only, five-year adjustable-rate mortgage that will reset in 2011. I have excellent credit, but the housing slump has resulted in the value of my home decreasing to $550,000.

My plan had been to refinance the $598,000 to a 30-year fixed rate when the ARM resets in order to reduce the high monthly payment that will then be due. It looks like I will have to pay off part of my loan in order to qualify for a refinancing into a smaller 30-year loan.

Do you think that is a good idea? Should I do it now or in 2011, when the loan resets?
— Kent Choices

Dear Kent,
First things first — you need to know what interest rate your loan is based on and the pricing spread to that index. Review your loan documents for that information. Then, estimate where the loan would be priced if it reset today.

Bankrate tracks most of the interest rates used for adjustable rate mortgages on its “Rate Watch: Track leading interest rates” pages.

I’ll be the first to tell you I don’t know where interest rates will be in 2011. My best guess is that long-term rates will have to go higher because of the inflationary impact from all of the recent government spending.

Short-term rates are even harder to predict. They could stay relatively low if the economy doesn’t find its sea legs, or they could move higher if the economy recovers. Since most ARMs are priced on short-term interest rates, it’s hard to guess what the rate will be when your loan is scheduled to reset.

Your loan payment could go up by a lot at the next reset in 2011 because the loan will no longer be interest-only, and the principal balance will be amortized over the remaining 25 years of the loan term. As the table below shows, if the reset rate remains at 6.15 percent, your monthly loan payment will increase by about $843 a month.

Mortgage payment scenarios
Current I/O loan Current I/O loan at reset 30-year fixed, 90% LTV 30-year fixed, 80% LTV
Loan balance: $598,000 $598,000 $495,000 $440,000
Interest rate: 6.15% 6.15% 5.18% 5.18%
Loan term (months): 300 360 360
Monthly payment: $3,065 $3,908 $2,712 $2,411
Difference from current payment: $843 ($353) ($654)
Additional principal payment: $103,000 $158,000
Total payments (includes additional payment): $1,172,382 $1,079,315 $1,025,836
Total interest: $574,382 $481,315 $427,836

The table also shows that paying down the mortgage today to refinance at today’s rates is a pretty daunting task. If we assume an 80-percent loan-to-value and that the home appraises at $550,000, your first mortgage is for $440,000, and you have to come up with $158,000 to pay down the outstanding current loan balance.

A 90-percent LTV has the first mortgage at $495,000, and you need to pay down the outstanding current loan balance by $103,000. With a 90-percent LTV, you will probably have to pay private mortgage insurance.

But if you have this kind of money available to pay down the mortgage, you shouldn’t face a financial squeeze by staying in the current loan and adopting a wait-and-see attitude toward home prices and interest rates.

How long you plan to be in the house is another factor to consider when deciding whether and when to refinance. If you plan to be a short-timer, refinancing doesn’t make sense. If you plan to be there for a long time, you can better justify the refinance.

I wish I had a definitive answer for you, but I don’t. Hopefully, I’ve discussed enough of the issues that it helped you form an opinion on what’s right for you. You have to balance the risks associated with staying in the current loan against the costs associated with buying down the loan and refinancing at today’s low rates.