Home Owner Loans - Playing the Mortgage Game

Back in the 1997-1998 period, when we we first scouted for houses, the mantra regarding home owner loans (mortgages) was to try and lock-in a standard 30-year mortgage at the historically low interest rate of around 8%. Five years later (2002) when we signed papers for our first house, the only difference in the mantra was that the historical low had slid to 6%. Two years later (2004), the variation for the story was that the average 30-year fixed interest rates for home owner loans had dipped below 6% for the first time. The story gets better when comparing with the current interest rate average of below 5% for 3-year fixed mortgages – historical low does not always imply an upward tick is imminent. In fact the reverse held true for the past decade and then some. The graph below detailing average 30-year fixed rates for home owner loans over the last thirty years is an indication of the wide-range possible:




Locking-in a fixed rate mortgage involves a premium to be paid upfront. Opting for low interest home loans such as an ARM mortgage would make more financial sense should the going trend indicate mortgage rates staying low for an extended period of time or if you plan to stay in the home only for a few years. We opted for a 7-1 ARM at 5.25% with a lifetime cap of 10.25% at 1% annual cap set-up from the eighth year onwards – we considered it a safe bet for we did not anticipate residing in that house much beyond 7 years. However, our stay in that home lasted only two years and so in hindsight a 3-1 ARM at below 5% would have been a better choice. Below is a graph that shows average 1-year adjustable ARM mortgage rates over the last twenty five years. It shows the large variance as well as consistently lower rates and correlation when compared to the classic 30-year fixed mortgage rates:




Another category of ARM mortgages that could offer even lower rates for home mortgages are the low interest home loans tied to the rates of less commonly used underlying indexes with very short fixed rate duration (1-month to a year). Based on the underlying index, the rates can be lower during certain time intervals and higher at other times when compared with the classic 15-year and 30-year fixed rates. There are times when the discount can be very significant, even when pitted against the best rates regular (3-1, 5-1, etc) ARM mortgages offer. Some of these also possess the vital "slow moving" feature, allowing nimble homeowners to make huge strides during certain opportune periods – specifically, when rates are following a steady to slow-rising trend, these mortgages allow “capturing” the lag built into the index. All else being equal, the best bet is the one with the highest fixed rate duration – initial 1-year fixed duration with adjustments every 6-months thereafter is a prudent and popular choice with these mortgages. The best options among such indexes for ARM mortgages are:
  1. COFI (11th District Cost-of-Funds Index): It is the weighted-average rate paid by 11th Federal Home Loan Bank District savings institutions for savings and checking accounts, advances from the FHLB, etc. The prime component is the interest paid on savings accounts which lag market rates in both uptrend and downtrend, thereby ensuring the index is slow moving, and
  2. MTA (12-month treasury average index): 12 month average of the monthly average yields of U.S. Treasury securities adjusted to a constant maturity of one year. Being an average of the previous twelve months, the index is slow moving.
It is very common for first-time home buyers to be confused between the mortgage types described so far and what are termed exotic home owner loans. The latter typically offer a teaser-rate and/or very low down payment. Such mortgages have higher overall costs associated with them and are very risky for the lender – it is all too easy to be lured into these rates and end up with a home that is not affordable. Option-ARMs are another choice that promises flexibility with respect to the monthly amount to be paid, but the downside risk is negative amortization. Nevertheless, these mortgages serve speculative real-estate buyers well by allowing them to enter deals at a relatively low on-going cost in the initial months – ideally, the turnaround of the property occurs in that time-frame as well.

To summarize, some ideas are clear from our experience:
  1. Low interest rates on home owner loans are relative. Locking in by opting for a 15-year of 30-year fixed rate is good provided you are relatively certain that rates will not slide further.
  2. Home owner loans categorized as regular ARM mortgages are a safe bet if you can foresee how long you anticipate keeping the house.
  3. ARM mortgages with short fixed rate duration tied to MTA, COFI, and other slow moving indexes work well when home owner loan rates are steady with an upward bias.
  4. Exotic home owner loans with teaser rates and/or low down payments along with option-ARMs are geared for speculative home buyers.
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Last Updated: 03/2012. 


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