The newspapers and television news have been full of chatter about the expectation of interest rates increasing soon. Some of it must be taken seriously, as when Federal Reserve Board Chairman Alan Greenspan speaks not of whether rates will rise but how quickly. Some of it is the mere pomposity of people trying to appear as experts. And some of it is pure hucksterism, coming from realtors and mortgage lenders: “Buy now, and lock in today’s low interest rates.”

These latter groups are particularly nervous about interest rates. Realtors make money only when a property sells. If interest rates go up, so does the monthly payment for a particular loan amount; someone who could previously afford a $300,000 mortgage might only be able to manage the payments on $288,000. Basic supply-and-demand economics indicate that you would then have fewer buyers in the marketplace; reduced demand causes lower prices; lower prices reduce the number of sellers, and so on till the market reaches equilibrium. The exact balance point is almost impossible to predict as it involves the visceral, not-fully-rational responses of individuals to change in their economic environment. But it will clearly involve fewer sales at lower prices.

Mortgage lenders face a similar dilemma. In addition to the interest paid over the term of the loan, lenders make money when a loan is created. That’s even true in a no-cost, no-points refinancing, though the lender’s revenue is invisible to the borrower. A large percentage of mortgage originations the last few years have been refinancings, whether to get a lower interest rate or to take cash out based on the appreciated value of the home. If interest rates go up, the volume of both refinancings and purchase mortgages will drop. That’s especially bad news for people like mortgage brokers who do not actually lend money themselves, but act as the conduit between the borrower and those who do.

Free Market Again

Among the surer signs that most people expect interest rates to rise is an increasing gap between fixed-rate mortgages and adjustable-rate ones. An adjustable-rate mortgage need only reflect the expected changes in market rates till the next change interval, while a fixed-rate one must consider the likely whole life of the mortgage. (Most 30-year mortgages are paid off much sooner, either because of refinancing or the sale of the property. The average is probably seven to 10 years.) As I write, one major Chicago-area mortgage bank is quoting a 6.625 percent rate for 30-year fixed rate mortgages, and 3.625 percent for those with interest rate adjustments every year. Clearly, higher rates are foreseen. A further analysis of their rate sheet suggests that they expect it relatively soon. Their six-month adjustable mortgage rate is only a hairs’ breadth lower than the one-year rate, but their three-year and five-year adjustable mortgages carry the same initial rate of 5.5 percent.

From a borrower’s standpoint, mortgage loans are a commodity with little loyalty to any particular supplier and are highly price-competitive. On the lender’s side, though, many other factors are involved. If a lender feels it has too many fixed-rate mortgages, it will keep those rates a touch high to discourage business and offer slightly lower prices on adjustable ones. Lenders also have to look to their own sources of funds. Good banking practice requires matching the rate volatility and maturity of the loans you make to that of the deposits you take in. Fixed-rate mortgages are typically sold off in packages to investors, and the interest-rate demands of that auction market also affect the rate a lender must charge.

Any Color So Long as It Is Black

Into the 1970s, homeowners’ mortgage choices were not much more generous than color selections on Model T Fords. You had fixed rate mortgages, period, though you did have some choice in duration: 20-year, 25-year or, the really daring, 30-year loans. But with the deregulation of banking, the growth of non-bank sources of mortgage funds like FNMA and FHMLC (“Fannie Mae” and “Freddie Mac”) and the explosion of inflation and interest rates during the Carter administration, adjustable-rate mortgages began to appear. Because the initial rates were always lower than fixed-rate loans, so were the payments; buyers can qualify more easily. Over the succeeding decades, virtually any imaginable variation on the formula was offered by some lender, but all had one thing in common. They were amortizing loans; that is, each payment included both principal and interest. The payment amount was recalculated at each rate change, but if you paid each month through to the 30-year mark, the loan would be paid off. In the last few years, even this constant has fallen. Many lenders are now offering interest-only adjustable-rate loans. These loans are tempting to many, because the payment – especially at today’s interest rates – is so much less than any amortizing loan. But using these loans means never owning the house “free and clear,” the once-cherished goal of our grandparents.

Clients often ask me for advice in selecting a mortgage. Almost any choice can be the right one, depending on your particular circumstances. Ironically, interest-only loans work best for those with substantial income and assets. For most retirement-age Americans, the equity in their home is their largest single asset; being able to cash out the value of the family home has been the difference between a comfortable retirement and a penurious one for many people. Moreover, you have to be able to afford a much higher payment if rates do go up. Many people find the certainty of a 30-year fixed loan comfortable, and if you stay long enough to make a major dent in the principal, inflation will have blunted much of the effect of a relatively high initial rate. But if you expect to be in your present home only five or seven years, you can get the same certainty at a lower rate with an adjustable loan that doesn’t change for the first five or seven years. And then there’s plain old math analysis: if your adjustable loan went up the maximum amount at each change date, how long would it be before you would have been better off with a fixed-rate loan? With today’s big gap in rates, that could be a long time.

Are there money or tax questions you would like to see discussed in this column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or call 773/5251778 (888/525-1778 toll-free outside the Chicago area) or e-mail greg@gregmermel.com.

Greg Mermel is a certified public accountant whose clients in the arts range from individual performers to major theatre companies and suppliers. He also has been known to produce theatre.

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