With rates rising, it's time to evaluate all your options
Chris Melvin figured it was time to move up. Sharing a cramped 800-square-foot house near Denver with his fiancee, Krissy Urick, a year ago he went shopping for bigger digs and soon found a four-bedroom home in Longmont, Colo. "It's just an average house in a nice little neighborhood," says the 32-year-old firefighter. "But it seemed like a good fit for us."
The financial fit was another story. Melvin lacked the cash for a traditional 20 percent down payment. Nor did he have the income needed to qualify for the best rates on a conventional fixed-rate loan. So a mortgage broker steered him toward what's known as an 80-20 loan package: an interest-only mortgage totaling 80 percent of the new home's $257,000 price, combined with a home equity line of credit to cover the 20 percent down payment.
Crunch time. The mortgage's 5.65 percent rate is fixed for the first five years, keeping Melvin's monthly payments low. But the credit line's floating rate has since ticked up by more than 3 percentage points, increasing his tab by about $100 a month. And with the chance that his total monthly payments could eventually double, he wonders if he should bite the bullet and refinance now.
Melvin is hardly alone. Over the next four years, about a quarter of all home mortgages will undergo a rate reset--almost certainly upward--on approximately $2 trillion in mortgage debt, according to estimates by the mortgage data firm LoanPerformance.
But switching now isn't necessarily the right choice. "If your rate is due to adjust within the next year or so, then, yes, you should probably refinance," says mortgage banker and syndicated columnist Lou Barnes. But for most people with steady jobs, ample savings, and a mortgage that doesn't adjust for an additional four years or more, "there's no reason to panic and do something just out of fear."
Even if interest rates do rise an additional percentage point over the next 12 months, "that's still pretty low by historic measures," says David Wyss, chief economist at Standard & Poor's. And with a cooling economy, "rates could even back off a bit after that," he adds.
No change. Wyss himself has no plans to refinance the seven-year adjustable mortgage he took out two years ago on his apartment in Manhattan. "At this point, I have a much lower rate than I could get on a 30-year fixed, and I'm not planning on staying in New York for another 30 years," he says. "So why make the change now?"
To figure out whether to refinance, people with adjustable-rate mortgages need to assess their financial and personal stability. How much cash have you set aside? What are the chances you'll relocate in the next few years? How stable is your job? And, for that matter, how's your marriage? "Even though it may be a remote possibility, you've got to consider the worst-case scenario," says Barnes, the mortgage banker.
For Melvin, it's a monthly payment that could double to about $2,500 when it resets. That's a nasty bite. But Barnes thinks Melvin's situation still doesn't warrant a rush to refinance. After all, his and his fiancÃÂÃÂÃÂÃÂ©e's jobs--as a firefighter and a cardiovascular specialist--are largely recession-proof, and both expect their incomes to increase substantially over time. Melvin also has about $20,000 in savings, money he can draw on to cover any shortfalls or pay down the loan.
But there's still a red flag: the $50,000 line of credit. Floating 3 percentage points above the prime rate banks charge, its 11.25 percent rate could go even higher. "The problem is that Chris doesn't have any equity in his home yet, which means he can't qualify for a better rate," Barnes says.
One solution: pay down the credit line and start building the 10 percent equity stake he needs to get a better rate. With the local market softening and the possibility that he'll stay put longer than he expected, "it's the best option," Melvin says of the additional $400 a month he plans to cough up. "And as long as we're sensible about how we budget, I don't see us getting in any trouble at all."
At least, he hopes not.
This story appears in the August 7, 2006 print edition of U.S. News & World Report.