(This is Part 2 of a seven-part series. See Part 1: Mortgage shopping: what you should know before you begin; Part 3: Three options available on most mortgages; Part 4: How long should you take to pay off your mortgage? Part 5: Investment returns influence real estate down payment; Part 6: Understanding choices in mortgage insurance and Part 7: Navigating real estate loan locks, docs.)

This is the second article of a series on the decisions mortgage borrowers should make prior to entering the market. This article is about the single most important decision of people’s lives: the type of mortgage.

Adjustable-rate mortgages (ARMs) have lower payments in the early years than fixed-rate mortgages (FRMs) but expose borrowers to the risk of higher payments in later years. Among different types of ARMs, those with a short initial rate period have lower initial rates and payments than those with longer initial rate periods, but carry greater risk of future rate and payment increases.

Many FRM and ARM programs today offer an interest-only (IO) option on which the borrower need only pay interest for up to 10 years. But lenders charge a higher rate (or points) for the option, and payments in the later years are larger.

Given the prices of various mortgages in the market, your selection of a mortgage type (including an IO option) should be governed by: 1) your time horizon — how long you expect to have the mortgage, and how certain you are about it; 2) your preference (if any) for low required payments in the early years of the loan; and 3) your tolerance for the risk of higher interest rates and payments in the future.

Here are some common situations:

1. Your time horizon exceeds 10 years and you don’t want any risk of rising payments:

An easy case, select an FRM.

2. Your time horizon is less than 10 years and quite certain:

If you are 95 percent sure that you will be out of your house within, say five years, select an ARM with an initial rate period of five years. Similarly, if your expected period in the house is three, seven or 10 years, take the ARM with the same initial rate period. In this situation, ARMs are relatively easy to assess, since your major focus is the initial rate. If you are out of the house before the first rate adjustment, you can avoid having to figure out what might happen at that time, as described below.

3. Your time horizon is less than 10 years but you aren’t sure:

This is a more complex situation, and also a very common one. In assessing it, you must balance the rate saving on an ARM during its initial rate period, with the risk that you will still have the mortgage when that period ends and that the rate will increase at that point. The rate saving is the FRM rate minus the ARM rate at about the same number of points. The risk is what might happen, perhaps the worst that could happen to the rate and payment in a rising market. If the rate difference does not justify the risk on a three-year ARM, you can try again on the five, seven, or 10-year ARM. If the risk is too great on all of them, select an FRM.

The tutorial on my Web site, How to Select Mortgage Features, provides some concrete suggestions for measuring risk on an ARM. It also describes a risk-reducing strategy used by some astute borrowers, which is to take an ARM but make the payment that they would have made had they taken an FRM.

4. You want to minimize the expected cost of the mortgage and are prepared to take the risk:

Borrowers who believe that interest rates are as likely to fall as to rise over the period they have the mortgage may select the loan that will have the lowest cost if rates don’t change. This is likely to be a six-month or one-year Libor ARM because they have margins that are often well below those on longer ARMs. The potential savings over an FRM would be even larger.

5. You have a short time horizon and want to buy as much house as you can:

Select an option ARM, on which the initial rate holds for a month. It allows the lowest initial payment of any ARM, usually below the interest-only payment, generating negative amortization–a rise in the loan balance. This ARM also has the greatest potential future payment increases.

6. You have a long time horizon and are risk averse but still want to buy as much house as you can:

Select an FRM with an interest-only option.

7. Your income fluctuates markedly, so you want a low required payment, which you can add to when you are flush:

Add an interest-only option to the mortgage you would otherwise prefer.

Next week: Selecting points and other mortgage options 

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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