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Mortgages

01/30/2005
Q. I am in the process of refinancing my mortgage for a major home remodeling project. It was suggested (with a wink and nod) that it would be wise to take a fixed rate conventional (5 3/8) instead of another VA ARM (currently at 4 1/4, 2% over 1 year constant maturity, +/- 1% per year max adjustment, 11% cap). Comments would be greatly appreciated. -- John Lamberg

John Kuhn responds:

I trade for myself, I say if asked, as it helps me not touch client portfolios of common stock which can often do better if left alone. Another thing I no longer mess with is home financing. After much diddling in the past, I've converted and would recommend a fixed mortgage. When things go awry, the last unpleasantness one wishes to heap on current troubles is a rising monthly mortgage outlay.

Increasing costs happen anyway. heat, water, elec, etc. Where I live, real estate taxes compound at over 5% per annum (since I installed my first computer tracker about 11 years ago) despite prop 2 1/2. Communities roll with the economic times and when times are good, the town managers are ingenious at coming up with vital "extras", new fire house, new high school, etc which the town approves in haste. These become part of the compounding base. Your real estate taxes will go up each year and if your experience is like mine, always by more than you expected.

The only thing that has grown faster than real estate taxes is home value: again a vindication of a good principle if you are young: get the biggest house you can handle.

In the past few years the most consistent mis-estimate has been expectation of increasing interest rates. Again now the sentiment is heavily tilted against duration by the bond gurus. Perhaps they will be wrong again. But all this tells me, after living in all kinds of unpredicted rate environments, is that consistent accurate prediction constantly confounds the experts.

It is very hard to move to a fixed rate at say 6 3/8 having passed on a 5 3/8. But if you have a fixed at 5 3/8 that is not several years old, it's easy enough to roll it to a lower fixed.

Jeffrey Beckwith adds:

The best way to make an informed decision on whether to go adjustable or fixed is to look at the payment schedules for each loan over a fixed horizon. Use the time frame you expect to be in the house as your time horizon. Look at the payments to be made on each loan using various interest rate scenarios. Develop worst case, best case and likely scenarios. Make sure you include lender fees and closing costs and prepayment penalties (if any) in your calculations.

Also look at the index of the ARM (in this case the one year constant maturity treasury) and make sure that you are comforatable with its profile versus actual rate moves. Does it lag actual rate moves? That may be good if rates are going up but it could be very costly if rates move down sharply and your index lags. This is not to say that you pick a loan based on what the index does but it is good to know how quickly the index moves in relation to rates.

While you are running numbers for these two loans you may also want to compare other loans types such 3yr or five year fixed that rolls to a 1yr ARM in the same manner just to see if there isn't another loan that may fit your circumstance a little better.