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Adjustable-rate mortgages are worth considering again


IN THE wake of the Federal Reserve's latest interest rate move, the mortgage market has an unlikely new wrinkle that you shouldn't ignore.

For the first time in many months, some of the most attractive deals for homebuyers and those refinancing can be found in adjustable-rate loans rather than fixed-rate mortgages.

In the days immediately after the Fed's half a percentage point rate cut, fixed-rate 30-year home loans actually rose slightly in price while adjustable-rate mortgages declined. That phenomenon, in turn, has created new opportunities for sharp-eyed borrowers to lock up 5 7/8 percent to 6.5 percent mortgage money, with minimal "points" or fees.

The Fed's rate cut was aimed only at the cost of short-term money. It had no direct effect on 30-year home mortgages, whose rates tend to track long-term bonds. In an indirect way, however, it might have nudged up 30-year loan rates, as investors began to anticipate stronger economic growth - and inflationary pressures - later in 2001.

Where the Fed's move made a big splash for homebuyers and those refinancing mortgages was in the segment of the market tied directly to short-term rates - adjustable-rate mortgages (ARMs). Almost immediately after the rate-cut, the gap between ARMs and 30-year fixed-rate mortgages billowed to more than 1 1/3 percentage points, the biggest spread in 2001.

According to Freddie Mac, the giant mortgage investor, one-year Treasury-indexed ARMs dropped to an average 5.81 percent after the Fed's move. Fixed-rate 30-year loans, by contrast, rose to 7.14 percent.

As recently as January, the gap between fixed-rate and adjustable-rate mortgages was microscopic - just 0.21 percent. That was nowhere near enough to make ARMs attractive and, in fact, not many homebuyers or those refinancing applied for them.

But now, with a relatively plump 1 1/3 percentage point advantage over competing fixed-rate loans, it's time for some loan applicants to seriously check out adjustables again.

As Frank Nothaft, Freddie Mac's deputy chief economist, put it in an interview, "why pay for 30-year mortgage money" at a premium price if you don't need to?

Who's best positioned to take advantage of the short-term rate drop? Borrowers who expect to be in their homes for a limited number of years, whether because of likely job transfers, family growth, an impending empty nest, or other foreseeable changes.

First-time homebuyers and those downsizing are excellent candidates for loans tied to short-term rates, Nothaft said.

What's available for them out there right now?

In last week's marketplace of 7 percent to 7.25 percent fixed-rate mortgages, some aggressive lenders were pricing so-called "hybrid" ARMs at or under 6 percent with zero or minimal "points." (A point equals 1 percent of the loan amount.)

A hybrid ARM offers a blend of adjustable-rate and fixed-rate features. It carries a fixed rate for an initial period, typically three to seven years, followed by rate adjustments once a year for the remainder of the 30-year loan term.

Many people who sign up for a hybrid ARM do so to reap the benefit of the initial, low fixed-rate period, and expect either to move, sell the house, or refinance before the rate adjusts.

Normally, three-year hybrid ARMs cost less than five- or seven-year hybrids.

A random sampling of Internet quotes last week turned up plenty of three-year hybrids at or below 6 percent, with anywhere from zero points to one point. Five- and seven-year hybrids went for anywhere from 6.25 to 6.75 percent, with zero to one point.

One-year, traditional Treasury-indexed ARMs were the cheapest of all - 5 percent with less than one point from some sources. But of course that guarantees you just one year at the 5 percent rate; if rates rise next year, you could be paying up to 7 percent on your mortgage, and possibly even more the next year. With a three-year hybrid at 6 percent and zero points, you're guaranteed that rate for the first three years.

Are there some pitfalls to hybrids? Absolutely. Here are a few pointers:

Rates. Don't be dazzled by a lender's low, posted rate --say 5.25 percent on a three-year hybrid. What fees and points come with that rate? It's often smarter on a short-term hybrid ARM to shop for the lowest rate carrying zero points. That's because the effective cost of upfront points is always greater over a shorter period.

Junk fees. Be on guard for large "processing," origination and other mumbo-jumbo fees that aren't mentioned on lender rate sheets, but get loaded on at settlement. They have the same impact as points on the true cost of your loan, and weigh heavier on short-term borrowers than long-term.

Prepayment penalties: Avoid them if you can.

Kenneth R. Harney is a syndicated columnist. Send letters in care of the Washington Post Writers Group, 1150 15th St. N.W., Washington D.C. 20071.

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