Part 2: Choosing a mortgage
Note: Total cost is total payments plus interest loss on such payments calculated at 2 percent, less reduction in the loan balance.
The results in this case indicate that even in a worst-case interest-rate scenario, where the rate increases by the maximum allowed by the ARM contract, the borrower is better off with the ARM if he is out within nine years. If rates increase only moderately, defined as an increase of 0.75 percent a year for four years starting after the first year, the borrower is better off with the ARM even staying as long as 13 years. In both cases, however, the borrower must feel comfortable with the payment increase he will face if rates increase and he still has the mortgage after seven years.
My general though much oversimplified rule: If total ARM cost is less than total FRM cost on a worst-case scenario over the period, that is your best guess as to how long you will be in the house, and if you believe you could meet the worst-case payment if necessary, select the ARM. If total ARM cost is greater than total FRM cost, or if you fear you would not be able to deal with the worst-case payment, select the FRM.
In next week's article, I suggest that many borrowers in today's market are making a mistake in selecting the combination of interest rate and points that would best meet their needs.
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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