SOUND MORTAGE CHOICES IN A RISING RATE ENVIRONMENT

By Larry Washington
Chairman and CEO of Merrill Lynch Credit Corporation

Rising interest rates have been making headlines lately.  Look a little closer and you will also see that shorter term rates, such as those used as benchmarks for popular adjustable rate mortgages (ARMs), have been rising faster than longer term rates.  The narrowing of the “spread” between rates on ARMs and fixed rate mortgages has potentially significant financial implications for anyone shopping for a new mortgage, as well as for homeowners who currently have an ARM and are concerned about the impact of higher rates.

The good news is that interest rates are still relatively low by historical standards, giving nervous ARM holders a chance to refinance and lock in reasonable fixed rates. Locking in a fixed rate loan is an increasingly attractive option for some homeowners, since a flattening yield curve has pushed up rates on many ARMs to the point where they are only a hair lower than fixed rate options. And for some homeowners, having an adjustable rate mortgage is the right mortgage for them. For example, if they expect to be in the home for only a few years, or if they think they may be able to pre pay some principal periodically to reduce the balance on which ARM interest is calculated.

Homeowners exposed to the risk of rising ARM payments should consider the features of various types of mortgages that can provide financial flexibility and a buffer against subsequent rate hikes. Assessing your personal situation now, before rates move higher, allows you to manage your real estate ownership and personal liabilities while staying on track to achieve long term financial goals.

Shrinking Interest-Rate Advantages

If you took out an ARM back in 2000, your interest rate and monthly payments shrunk as the value of your home likely shot skyward.  Indeed, ARMs were big bargains for homebuyers during most of the current real estate boom. The rate on ARMs dropped steadily as the Federal Reserve cut the short term federal funds rate from 6.5% in January 2001 to a low of 1% by June 2003. The average rate on a one year ARM over that same period fell nearly four percentage points from 7% in late 2000 to 3% by early 2004.

In June 2004, however, the Federal Reserve reversed course and began hiking rates to fight potential inflation. After a dozen quarter-point hikes over the next 16 months, the federal funds rate was back up to 4% by November 2005. The six month London Inter Bank Offering Rate (LIBOR), on which many ARMs are based, nearly quadrupled from 1.16% in March 2004 to 4.6% by November 2005, while the average interest rate on a one year ARM rose from 3.0% to 4.5%.

As the Fed boosted short-term rates by 3%, longer-term interest rates such as the yield on the 10-year Treasury note (a popular benchmark for fixed rate mortgages) barely budged. The quicker rise in shorter maturities has resulted in a flattening of the yield curve and a shrinking of the once substantial interest rate advantage offered by ARMs versus fixed rate mortgages.  For example, in 2003, the rate on a one year ARM was 2.5% lower than the average fixed rate; by late 2005, the spread between the ARM and the fixed rate had narrowed to 1.25%.

Weighing Fixed Rate Time Frames

A traditional rule of thumb that is still appropriate for most homebuyers and owners who are weighing mortgage options is to match the time you expect to own a property with the period of time that the rate is fixed. For example, if you expect to own a home or investment property for less than five years, an ARM with a rate that is fixed for the first five years and adjusts thereafter might be appropriate and give you sufficient insulation from rising rates.  If you plan to own a home for the long haul, a longer term fixed rate might be a better choice.

With such a small rate differential between short and long term rates, it costs relatively little to be conservative and lock in the rate for a longer period if you are uncertain how long you will own the property. While a one year ARM may have been a winning proposition in a falling rate environment, the opposite is true as rates rise.

If you currently have an ARM that is nearing the end of the fixed rate period, consider locking in a fixed long term rate. You may be comfortable with the idea of fluctuating payments and rates on your ARM, but you should calculate the real dollar impact they will have on your cash flow situation and long term financial goals.

Maintaining Cash Flow Flexibility

The right mortgage for your needs depends not only on rates, but also on the specific loan terms. In today's lending market, there are many varieties of mortgages and tailored solutions from interest only products to short and long term loans. Interest only loans are available as both fixed rate and adjustable rate loans and allow for cash flow flexibility since borrowers are only required to pay interest each month.  However, you could also pay the loan according to a standard amortizing schedule and pay only interest when you need extra cash.

Another source of cash is a home equity line of credit.  Although home equity rates have moved sharply higher, interest on most forms of home equity debt is typically tax deductible, making it competitive with other borrowing options. Home equity lines generally are inexpensive to establish and can be particularly helpful as a ready source of funds in the event of unforeseen circumstances. However, you should always consider your ability to pay off a line of credit before you establish one.

A home mortgage is one of the largest debts you are likely to incur. The right option for you needs to consider your entire financial picture, lifestyle and goals. It can also potentially improve your cash flow, free up resources for other financial goals and increase your potential tax deductions.

All residential mortgage programs are offered and funded by Merrill Lynch Credit Corporation ("MLCC"), 4802 Deer Lake Drive East, Jacksonville, FL 32246-6484; toll-free telephone: 800-854-7154.

• AZ License BK-10071;
  
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• IL Residential Mortgage Licensee;
  
• MA Mortgage Lender License ML1436 & ML2078;
  
• Licensed by the New Hampshire Banking Department;
  
• Licensed by the NJ Department of Banking and Insurance;
  
• RI Licensed Lender.  
  
• This is not an offer to enter into a rate lock-in agreement under Minnesota law.  

An offer may only be made in writing.  MLCC is a primary and secondary mortgage lender.
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