Tuesday, September 07, 2004

Make the Most of Your Mortgage

With the right loan, it's still possible to save a bundle. Here are two savvy strategies to beat rising rates.
Tuesday, September 7, 2004
By Janice Revell

Whether you're eyeing a vacation property, looking to refinance, or thinking about how to help your kids get into a starter home, the array of mortgage options can be dizzying. Mix in a nagging uncertainty about the economy and where interest rates are headed—it's enough to make even the most sophisticated homebuyer lightheaded. We've got a couple of strategies for making the best of this tricky rate environment.

Don't say farewell to ARMs
With mortgage rates still hovering close to their 30-year low, conventional wisdom would seem to indicate that it makes sense to lock into a 15- or 30-year fixed-rate loan right now. And indeed, about two-thirds of all American homeowners are doing exactly that. After all, the Federal Reserve has already hiked interest rates twice this year, and the overwhelming sentiment among experts is that rates will trend up, not down.

But that doesn't necessarily mean that a fixed-rate mortgage is the best choice. In fact, if you're looking to maximize your return on investment, an adjustable-rate mortgage, or ARM, may be a far better option. With an ARM, you get an introductory period in which you pay a lower interest rate than you would with a fixed loan; after that, it can then fluctuate up or down. Inflation fears, of course, have made that fluctuation a scary prospect, driving many consumers into the safety of a fixed-rate mortgage. But when you purchase the latter, you're also buying something else: an insurance policy that protects against further rate increases. And you're paying a juicy premium for that insurance in the form of a higher mortgage rate.

In fact, that hefty premium is the main reason homeowners ought to think twice before locking into a long-term loan. Even Fed chairman Alan Greenspan weighed in on the topic recently, cautioning that fixed-rate mortgages can be a bum deal for many homeowners—especially those who "are willing to manage their own interest rate risks."

But to use an ARM effectively, you'll have to be proactive. Rates, now at rock-bottom levels, could easily be higher in a few years' time. But you can take steps to hedge against that risk and still reap the benefits of the lower rate provided in the initial years of the ARM—if you trust yourself to be disciplined with your cash.

Take the example of a homebuyer who wants a $400,000 mortgage. Right now the rate on the fixed portion of a 5/1 ARM—which is guaranteed for the first five years and adjustable thereafter—is 4.57%. After that it's tied to an index (such as the one-year Treasury security) stipulated in the loan agreement. Typically rates can rise by a maximum of two percentage points per year after the initial fixed period is over and by no more than six percentage points over the lifetime of the loan. Alternatively, our hypothetical borrower might choose to get a 30-year mortgage that locks in an annual rate of 6.1%. So what's the better deal?

FORTUNE asked Greg McBride, an analyst with mortgage tracker Bankrate.com, to crunch the numbers on both of these mortgage options. To be conservative, we asked him to assume the worst-case scenario with the ARM—one in which the rate on the loan jumps by the maximum allowable each year. (It's possible. In 1994 the one-year treasury index nearly doubled, to 7.2%.) Here's what would happen: For the first five years our homebuyer's monthly payments on the ARM would be $2,043— $381 less than what he'd pay under the 30-year mortgage. Over that period, he'd save a total of $22,860 in payments and build up an additional $7,770 in equity.

Of course, after the initial five years the payments under the ARM would balloon, to $3,425 by the eighth year of the loan. But it's not until the ninth year of the loan that the savings garnered by lower payments during the first five years would be wiped out entirely. (For simplicity, we didn't calculate the mortgage-interest tax deduction, which would have been greater on the fixed-rate loan for the first few years but higher on the ARM thereafter.)

But this doesn't factor in the extra wealth our buyer might generate by taking the $380 monthly savings from those first five years of the ARM and putting it to work. For instance, if he were to put the money into a 401(k) plan, receive a company matching contribution of 50%, and then earn an average annual return of 8%, he'd have an additional retirement nest egg of almost $300,000 in 30 years.

Alternatively, he might choose to apply the monthly savings to the principal balance of his mortgage. If interest rates rise sharply thereafter, he can always refinance into a more favorable fixed-rate loan. Thanks to the extra principal he paid down, the monthly payments under the new loan might not increase much at all—and he'd be on track to have the mortgage off his books years sooner.

The bottom line: Even in the worst-case scenario, if our homebuyer was planning to move to a new place within nine years or so, he'd be much better off with the ARM. That also assumes our hypothetical buyer is able to stomach the increased payments that kicked in after the first five years of the loan.

By the way, if you are one of the few holdouts who hasn't refinanced your mortgage—or if you're thinking about doing it again—this same logic applies to you. Just be sure to check that the closing costs don't cancel out the benefits of a lower rate. If you're planning to move in two or three years, refinancing from an ARM into a fixed-rate mortgage may generate no net savings at all.

Keep it all in the family
Looking for the lowest mortgage rate out there? You won't find it at the bank. Rather, the best deal may be right at home with what's known as an "intrafamily" loan. Through this legal arrangement, any individual—despite the name, it's available not just to relatives but also to friends and even complete strangers—can lend money to a homebuyer at rock-bottom rates. If the loan is structured properly, it can be a win-win situation for both parties.

Here's a simplified example of how it can play out: Let's say you want to lend your son $100,000 toward the purchase of a new home. As long as you draw up a formal mortgage contract stipulating an annual interest rate that's no less than the "applicable federal rate" established by the IRS (posted monthly at www.irs.gov), he'll be able to take the mortgage-interest tax deduction. If you want to set up a 30-year fixed-rate mortgage, for instance, you could stipulate an annual rate as low as 5.03%.

At this point you'd have two choices, says Greg Hayes, a partner who specializes in estate planning for law firm Day Berry & Howard, based in Stamford, Conn. First, you could collect the interest payments (which you must report on your tax return) and earn a return that is much higher than the yield being offered by the typical five-year CD (right now averaging about 3.5%).

Another option is to forgive the interest payment in any given month or year. Under current tax law, you may give $11,000 per year to any one individual without triggering the so-called gift tax, which can amount to almost 50% of the amount you give away. (Hayes points out that you need to set up the loan in a way that makes it clear you're not intending to waive the interest charge year after year—in that case, he says, the IRS is likely to view the loan as a gift and tax you on it.)

Even though you didn't receive the interest income, you'd have to report it on your tax return. Your son, however, would still get the mortgage-interest tax deduction—in essence, you'd simply be transferring a tax benefit to him.

And no matter who you choose to lend money to, just make sure you go into it with your eyes wide open. "I have seen people who considered themselves friends foreclose on each other," says Hayes. And that's never a good deal.