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Should We Fix Our
Mortgage?
"My husband got
us into a variable rate mortgage and I would like to change it to a fixed
rate. We are paying 8% now and I am scared about the rate we will be at in
the next 10 years. Can you give me some advice? We have only had the house
for three years. We do not have the best credit either." ~ Lisa
Sounds like Lisa might not be too happy with the mortgage that her husband
got them into'. And, she's right, there are some risks with variable rate
mortgages. But, there are also some advantages. In fact, in many ways, Lisa
and her husband are in a good position to manage their mortgage expense.
Let's look at both the risks and the advantages. The obvious risk is that
the cost of housing for Lisa's family can change. And for an item that typically
takes about one third of your budget, that's cause for concern.
But that unpredictability does have an advantage. Because the lender doesn't
have to commit for 15 or 30 years, they can charge you a lower rate of interest.
Typically you'll pay about 1% less than on a 15-year fixed and about 1.25%
less than a 30-year fixed mortgage.
The reason is that the lender is taking a serious risk with a long term mortgage.
If interest rates go up, they're stuck earning the lower interest rate. And
that costs them money. On a 30-year mortgage the costs can be significant.
So to cover that risk, they charge you a higher rate of interest.
On the other hand, if rates go down, many borrowers will refinance their
mortgages to the new lower rate. So the lender can lose no matter which way
rates go.
A variable rate mortgage is much nicer to the mortgage company. If rates
go up you pay more. If rates go down, they'll make less, but their costs
go lower, too. The trick for Lisa is to use these facts to her advantage.
she currently has a variable mortgage. Should she switch to a fixed rate?
The first thing she'll need to find out is how much it will cost in upfront
costs to go to a fixed rate mortgage. There are a variety of 'closing costs'.
It's not uncommon for them to add up to 3% of the mortgage amount. Some of
those costs can be avoided by staying with the existing mortgage company.
So include them in your list of mortgage companies to consider. A simple
call to your existing mortgage company will provide you with the details.
Before Lisa and her husband make a decision, there's one more question to
consider. How long do they expect to live in the house? We all think of a
home as something that's forever. And, while the building will probably last,
it's not likely that we'll live in it for more than seven or eight years.
So if Lisa has already been in her house for three years, it's possible that
they might in just a few years.
Why is that important? Most variable rate mortgages have a ceiling to the
amount of increase in any one year. For illustration here, let's assume that
Lisa's rate can only go up 1% per year. So if she's only going to be in the
house for four more years, the highest the rate could get would be 12% (8%
now plus an additional 1% per year for four years).
And knowing that, Lisa can construct a spreadsheet that shows how much more
she'd pay each month for the next four years. That will tell her the maximum
amount she could spend on mortgage payments. If she'd like someone to calculate
the monthly amounts at each interest rate level, a call to her mortgage company
should provide the answer.
The next step is to compare what a fixed rate mortgage would look like. To
do that she'll need to start with her closing costs. Then add the monthly
cost for the same four year period. The two combined will give her the total
cost for the fixed rate mortgage. Again, the mortgage company is the best
source for the amount of closing costs and monthly payments.
One note. Lisa will need to treat the cost of any private mortgage insurance
or escrow accounts for property taxes and homeowners insurance the same in
both cases. Don't include them in one and leave them out of the other.
My guess is that if Lisa will be in her house for five years or less, she's
probably going to do better by staying with the variable mortgage. But if
she plans on being in the house for ten years or so, the fixed would prove
to be the better option.
One final thought. Lisa mentioned that her credit wasn't perfect. While that
doesn't exclude her from getting a new mortgage, it could mean that she'll
pay a higher interest rate. When she checks on the cost of a new mortgage
she'll need to be honest about her credit situation to get a realistic figure.
There you have it. For a few phone calls and about an hour at the kitchen
table with paper and calculator, Lisa and her husband can get a pretty good
feel for what options are available and what each will cost. And armed with
that knowledge, they can make a decision that works best for their
family.
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Gary
Foreman is a former Purchasing Manager and Certified Financial Planner.
He currently edits The Dollar
Stretcher website. It contains the web's largest collect of free articles
to save you time and money. There's even a free weekly email newsletter.
Visit and save some money today!
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