Short-term vs. long-term loans

Part 2: Mortgage selection in post-crisis market

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Editor’s note: This is Part 2 of a two-part series. Read Part 1 here.

Last week I noted the large price differences between fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs), and between ARMs with different initial-rate periods. These differences largely reflect market expectations that future rates will be higher. When lenders expect higher future rates, they encourage ARMs by pricing the initial ARM rate low.

Selecting among different FRMs: The price differences between FRMs of different term are also unusually large. On Jan. 8, the rates for prime borrowers on 40-,30-, 25-, 20-, 15- and 10-year terms were, respectively, about 5.625 percent, 5.125 percent, 5.125 percent, 4.625 percent, 4.5 percent and 4.25 percent.

These differences largely reflect the increased importance lenders now attach to borrower equity as their protection against default.

With home prices no longer rising, the faster paydown of loan balances on shorter-term mortgages has enhanced value. Lenders will cut the price if you commit to paying down the balance faster.

Selecting the term is, in a sense, a judgment by the borrower of the relative importance of the present and the future. A longer term has a lower payment, which favors the present, but has a slower paydown of the loan balance, which is burdensome in the future.

By pricing short-term loans lower, the market encourages borrowers to favor the future, but this runs against the very powerful tendency of most borrowers to focus on the present. While clearly the payment must be affordable, many borrowers could afford more but give the future a low priority.

The price of being fixated on the present can be high. Let’s take the extreme case of a 10-year vs. a 40-year term. On a $100,000 loan, the payments are $524 (40-year) and $1,024 (10-year), almost 2-to-1.

The borrower taking the 40-year saves $500 a month in payment, or about $30,000, over the first five years. But at the end of the five years, that borrower will owe $96,161 compared to only $55,282 owed by the borrower who took the 10-year. The difference in balances is $40,878 compared to the $30,000 difference in payments. The larger difference in balance is due entirely to the lower rate on the 10-year.

The borrower with the 40-year paid $10,878 more in interest.

Some borrowers who can afford the higher payment on a shorter term select a longer term with the intention of investing the difference in cash flow. This is a really dumb idea, even for a borrower who has the iron discipline required to execute it. The pitfall is that, because of the higher interest rate on the longer-term loan, the return the borrower needs to earn on the cash flow to come out ahead is just too high.

For example, if the borrower selects the 30-year loan at 5.125 percent rather than the 15-year at 4.5 percent, he has to earn 6.73 percent over the 15 years just to break even. If the loan is paid off in 10 years, the breakeven rate is 8.12 percent. And over five years, it is 12.35 percent. I don’t recommend this strategy. …CONTINUED

Selecting an interest-only payment option: A mortgage is "interest only" (IO) if the required payment for a specified period, usually five to 10 years, consists only of the interest, though borrowers have the right to pay more if they want to. The option to pay interest only carries a price, relative to the price of the identical mortgage without the option.

The price is higher than it was before the financial crisis, reflecting the heightened importance lenders today attach to balance reduction as a way of reducing default risk.

On a prime loan with 20 percent down, ARM borrowers pay a rate about 0.375 percent higher for a loan with an IO option. On a 30-year FRM, the rate is about 0.5 percent higher. If the loan is a cash-out refinance, the price difference is more like 0.75 percent. And when the loan is on an investment property, it rises to 1 percent.

A tutorial on my Web site identifies six reasons borrowers might have for selecting a loan with an IO payment option. I don’t recommend doing it to invest the cash-flow savings, for the same reason I wouldn’t select a longer term. Because of the higher interest rate on the IO, the return you need to earn on the cash flow to come out ahead is too high.

Neither is this the time to use an IO to stretch the amount of house you can buy, or to finance a quick in-and-out transaction.

Borrowers with fluctuating incomes who attach a high value to the flexibility the IO mortgage gives them may find the IO price worth paying. When their finances are tight, they can make the IO payment; and when they are flush they can add a substantial payment to principal. Such borrowers must be disciplined enough to make the payment to principal when they aren’t obliged to.

Another group of borrowers who may find an IO worth the price are those forced to close on a house purchase before their existing house is sold, and want to use the proceeds of the sale, when it occurs, to reduce the payment on the new mortgage.

IOs are the only mortgages on which a payment that reduces the balance results in a lower required payment the very next month. However, not all IOs work this way. On some the payment doesn’t change until the anniversary month, and on others it doesn’t change until the end of the IO period.

Anyone contemplating an IO in order to obtain an immediate payment adjustment feature needs to inquire about this. Note: Get it in writing!

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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