real estate

How to Deal With Volatile Mortgage Rates

If you plan to buy and are concerned about rising rates, don't procrastinate.

In June, the Federal Reserve confirmed that as the economy continued to improve, it would begin to wind down its purchase of mortgage-backed securities, a program designed to support the housing market by keeping mortgage interest rates low. Reacting to the Fed's announcement, the average for a 30-year fixed-rate mortgage shot up to nearly 4.5% -- almost a point higher than six weeks earlier. But that's still historically low, and as the markets settle, rates should go back down a bit. Kiplinger expects the 30-year loan rate to be 4.25% by year-end.

If you need a mortgage, lock in the best rate you can get now, and don't worry about having missed out on the lowest-ever rates. "Remember that a good, normal, 30-year fixed rate is 5%, but nobody wants to hear that when they've seen 3.5%," says Guy Cecala, publisher of Inside Mortgage Finance.

Plus, even in places with double-digit increases in home prices, values still haven't returned to the housing market's peak nationally in 2006. With a national median home price of $200,000 in the second quarter of 2013, home prices are still 34% below their crest, reports Clear Capital, a real estate data provider. And homes are still affordable throughout most of the country, except for high-priced coastal California and the D.C.-to-Boston corridor, according to a home-value and interest-rate analysis by Freddie Mac. Freddie Mac said recently that mortgage rates would have to rise to nearly 7% before the median-priced home in the U.S. would be unaffordable to a family making the median income in most parts of the country.

Still, buyers who were on the edge of qualifying for a home may have to rethink their options. Monthly payments (of principal and interest) on a $200,000 mortgage at 3.5% are $898. At 4.5%, payments are $1,013. As rates rise, you could put off your home purchase until you see rates fall, but that's a risky proposition if home prices rise in the meantime. If qualifying for a larger monthly mortgage payment isn't in the cards, then you have a few alternatives: You can choose a less expensive home or increase your down payment to reduce the size of your loan. You can pay more points (one point equals 1% of the loan amount) to buy down your rate with prepaid interest. Or you can take out an adjustable-rate mortgage with a lower starting interest rate.

The ARM option. Adjustable-rate mortgages earned a bad reputation during the housing bust because of risky features -- super-low teaser rates and super-high rate adjustments -- that no longer exist. Today, a hybrid ARM (the interest rate is fixed for a number of years and adjusts annually thereafter) is a safer choice.

Choose one with an initial fixed-rate period that matches how long you expect to remain in the home or keep the mortgage. In late June, the average rate nationally was 3.2% for a 3/1 ARM that adjusts after three years, 3.37% for a 5/1 ARM and 3.89% for a 7/1 ARM, according to HSH.com, a rate-tracking service. Also, consider what the payment would be if the interest rate rises to the maximum allowed at the first adjustment (often to a cap of two percentage points).

Many credit unions offer a 5/5 ARM. The starting interest rate remains the same for five years, then adjusts (typically with a cap of two points) every five years thereafter. At Navy Federal, for example, the initial interest rate on its 5/5 ARM in early July was 2.375%. In five years it could adjust to 4.375%, just slightly more than the average 30-year fixed rate at the time of origination.

To help relieve rate anxiety, you can lock in your mortgage rate until you close. The longer the lock-in period (typically 30, 45, 60 or 90 days), the greater the cost -- generally an eighth of a percentage point for every 15 days beyond an initial 30 days. Some lenders offer a free, one-time "float down" feature if rates decrease before closing; others will charge a fee, for example, of an additional 0.125 point on your rate.

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