Rates on ARMs become less attractive, and "exotic" mortgages lose their luster. For many buyers and refinancers, a 30-year, fixed-rate loan is a better, safer bet. By Pat Mertz Esswein, Associate Editor February 28, 2006 Home buyers and refinancers, take note: Your choices aren't pretty. Rates on popular adjustable-rate mortgages have spiked, and fixed rates are creeping up. Plus, "exotic" mortgages that let you pay interest only or choose the size of your payment are going the way of oversize SUVs. All these forces will crimp how much house you can afford if you're in the market this year. ARMs accounted for about one-third of mortgages last year -- a big jump. But the vast majority were interest-only loans or ones that let you pay even less than the nominal rate -- called option ARMs -- reports data provider Loan Performance. These nontraditional mortgages were creations of the torrid housing markets, as buyers stretched to afford higher-priced homes. Investors also used these loans to keep payments low until they could flip properties. The exotics won't disappear, but the go-go days are over. Bank regulators are making lenders tighten requirements to make sure that borrowers won't be overwhelmed by steep payment increases that may occur. And lenders are being told to better explain risks. For example, with a traditional 30-year mortgage you accumulate equity with each payment -- 6% to 7% of the original balance after five years at today's interest rates. If you pay interest only, you're betting on appreciating prices to boost equity. If prices have fallen when it comes time to sell, you may have to come up with cash to pay off your loan -- especially if you took advantage of another popular option and put little or nothing down on your home. Fixed rates trump ARMs The allure of adjustable-rate mortgages -- which typically offer lower rates than fixed-rate loans -- is disappearing. The spread will decline this year to less than one percentage point, says Fannie Mae. Meanwhile, at a recent average of 6.2% for loans of less than $417,000, 30-year fixed-rate mortgages are still near historic lows. Kiplinger's expects that the average rate will settle between 6.5% and 7% by year-end. Advertisement The slow rise in 30-year fixed-rate loans offers at least some consolation for anyone who has been waiting to buy. Say you expect to put down 20% on a $500,000 home to avoid private mortgage insurance. A year ago, with an interest rate of 5.7%, your monthly payment on the $400,000 loan would have been $2,321, excluding taxes and insurance. This year, with a rate near 6.2%, your monthly payment would be $2,449, or $128 more. To entice borrowers who might be put off by higher rates, lenders will continue to offer artificially low starter rates. By the end of 2005, lenders had reduced their teaser rates on one-year ARMs by a half-percentage point from the year before, even though the indexes on which they're based were higher, according to a Freddie Mac survey. With a one-year ARM that has an initial rate of 5.2%, your monthly payment on a $400,000 loan would be $253 less than a fixed-rate mortgage at 6.2%. But after the first adjustment, the ARM would cost $266 more. A hybrid ARM -- which has a fixed rate for up to ten years, then adjusts annually -- can still be a good choice if you plan to move in a few years or you expect your cash flow to improve. In the previous example, a 5/1 hybrid ARM at 5.8% lowers the monthly payment by $102, to $2,347, compared with the fixed-rate loan. But Glenda Moehlenpah, a financial planner in San Diego, warns her clients to distinguish between certainties and "mights," and she urges them to consider the worst-case scenario: Your means don't improve, you can't sell your home, and you get hit with the maximum interest-rate adjustment (usually two percentage points annually). Moehlenpah also points out that many borrowers who think they can painlessly refinance out of an ARM have failed to read the fine print. Most ARM borrowers have agreed to a prepayment penalty in exchange for a lower interest rate or reduced fees. This stipulation typically applies up to five years. Advertisement Interest-only niche Some lenders claim that interest-only mortgages are useful tools for borrowers who educate themselves about what they're getting into. With an interest-only ARM for some period of time -- usually the first five or ten years of the loan -- you have the choice of paying your usual monthly payment of principal and interest or paying just the interest. On a $400,000 5/1 ARM with a rate of 5.8% and an interest-only option, you would pay $413 less than the principal-and-interest payment of $2,347. Jay Fields, of Wells Fargo Home Mortgage in Las Vegas, says that is an attractive option for borrowers who have cyclical income, such as commissions and bonuses, and want to manage their cash flow in tight months. But he urges his clients to exercise discipline. "I tell borrowers that the money they're saving is for investment, retirement or college, not to go to the casino." Belinda and Mark Lambrite, who recently moved from Las Vegas to Windermere, Fla., outside Orlando, are using an interest-only ARM to their advantage. Mark, 39, is a manufacturing-plant manager who relocates frequently, so the couple prefers hybrid ARMs because they're likely to move before the first rate adjustment. The Lambrites chose a 7/1 ARM with an interest-only option for their Florida home. They'll use the option until Belinda, 43, returns to work as a trauma nurse. When she does, they will make payments against the principal; if she doesn't, they won't be strapped. Where might a market slowdown leave the Lambrites? They had a nice kitty to start with: the $335,000 they made when they sold their Las Vegas property. They put $300,000 of it down on their new, $650,000 home. If their home in Florida doesn't appreciate, and even if prices fall, they won't have a problem paying off the loan and covering real estate commissions when it's time to sell. Advertisement Another way to stretch your buying power is to take a mortgage with a longer term. For the privilege, you'll pay a slightly higher interest rate. At 6.5% on a $400,000 40-year mortgage, monthly payments would be $2,327, $122 less than with a 30-year term. Lenders are also considering mortgages with 50-year terms, which in this example would lower your monthly payment by $88. Don't max out As home prices rise, it's natural to want to buy the biggest house possible with the smallest down payment. That gives you a bigger return on your investment. But if you have a choice, taking on a bigger mortgage to buy a house that's more expensive may no longer make sense now that price hikes are slowing, says Peter Miller, author of The Common-Sense Mortgage. If you're selling during a cooling market, you could have a smaller pool of prospective buyers. "It's not always easy to sell the biggest house in town," says Miller. Downsizing also helps ensure financial flexibility, even if you don't plan to sell anytime soon. Many homeowners have been tapping their rising home equity as a built-in emergency fund. If the equity isn't there to tap, or your home-equity-line payments soar, you could feel strapped. Says Miller: "When two working adults who are never at home buy a barnlike creation in the suburbs, it violates my first rule of real estate: Never buy a house you don't want to clean."