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September, 2003 Tax Tip

The Right Loan for Your Home

Today's still relatively low interest rates make 30-year fixed-rate mortgages pretty attractive. But, is a 30-year fixed-rate mortgage the best way to go? With so many mortgage products to choose from, how do you decide which is best for you?

Assuming you have no problems qualifying for a loan, the decision will depend on your personal goals as well as your tolerance for risk. An ARM is riskier than a fixed-rate loan because the interest rate and monthly payment might go up over time. Borrowers with a low tolerance for risk, or who live on a fixed-income, often prefer a fixed-rate mortgage with an interest rate and monthly payment that won't change.

The length of time you plan to stay in your home is also an important factor. If you're pretty sure that you won't be moving for seven to 10 years, a 30-year fixed-rate loan might be best for you. As of the date of this article these mortgages are currently available in the percent range.

On the other hand if you are rather certain you'll be moving within the next five years, you will save money with a 5-year fixed-mortgage product. These are currently available in the 5 percent range. For the first five years, the interest rate is fixed. Then the mortgage converts to an ARM. The specifics will vary from one 5-year fixed product to another.

A common variety is called a 5/2/5 mortgage. The interest rate is fixed for the first five years. After that, the rate adjusts. The rate can only move up 2 percent in any one year. And over the life of the loan, the interest rate cannot rise more than 5 percent from where you started. So, if you started at 4 percent and interest rates rose to 12 percent, the most you'd ever pay would be 9 percent. However, on the first adjustment only, the rate can adjust up the full 5 percent allowed if the index the ARM is tied to has gone up 5 percent or more since you took out the loan.

While rates have been rising, it's hard to imagine that they will ever hit 9 percent again. But 20 years ago, we were sure we'd never see rates drop below 10 percent. Interest rates are expected to stay reasonably low for some time. However, as many of us know, financial markets can change quickly, and without warning.

I advise my clients to consider the worst-case scenario before choosing a 5-year fixed-rate product. Assume you don't move at the end of five years as you thought you would. Calculate how much the loan will cost you if interest rates were to skyrocket during the fixed-rate term of the loan and you ended up having to pay the maximum rate allowed for several more years.

Fully adjustable-rate mortgages are currently available in the 4 percent range. Some of these loans adjust monthly. Although riskier, these loans are popular with borrowers who need quick financial relief. These loans are also the easiest to qualify for. The 15-year fixed loans are popular with borrowers who want to own their homes free of any debt in a shorter time. These loans are harder to qualify for due to the higher monthly payment. To avoid being stressed out financially with the higher payment that accompanies a 15-year fixed loan, I suggest to my clients that they take a 30-year loan and, whenever possible (hopefully each month), add an additional amount to their monthly payment. Depending upon the amount added, this can dramatically reduce the loan term without the commitment to make the extra payment each month. One caveat you need to make sure your loan doesn't have a prepayment penalty.


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