Copyright (c) 2006, 
Dow Jones & Company Inc. Reproduced with permission of copyright owner. Further reproduction or distribution is prohibited without permission.NEED A NEW mortgage? It may be time to take a fresh look at your options.
In recent years, many borrowers have embraced adjustable-rate mortgages as a way to lower their monthly payments. They also have flocked to exotic loan products, such as mortgages with 1% teaser rates, so they could buy a more expensive home or tap their equity without boosting their monthly payments.
But last year's top loan choice might not be the right one for 2006. One big reason: The gap between short-term and long-term rates has narrowed. This flatter yield curve means that borrowers aren't saving as much as they once did by taking on the interest-rate risk that comes with an adjustable-rate mortgage, or ARM. At the same time, mortgages of all types have gotten more expensive.
"The bloom is off the ARM market," says Doug Duncan, chief economist of the Mortgage Bankers Association, a trade group in Washington. More borrowers are now taking out fixed-rate loans, he says, or ARMs with longer fixed periods.
To be sure, which type of mortgage makes sense depends on a host of factors, including how long you plan to stay in the home and the size of your wallet. Your outlook for interest rates also can make a difference. A borrower who believes that rates are near their peak and will soon begin falling, for instance, may be more comfortable taking out an ARM than someone who expects rates to continue to ratchet upward.
Here, then, is a look at some of the options:
FIXED-RATE MORTGAGES
Fixed-rate mortgages seemed almost passe when interest rates were declining. In a speech in 2004, Federal Reserve Board chairman Alan Greenspan noted that "many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade" as interest rates tumbled.
But with rates moving higher, fixed-rate mortgages are regaining some of their allure, particularly for borrowers seeking safety. Fixed-rate mortgages now account for about 72% of mortgage applications, according to the Mortgage Bankers Association, up from 63% in March 2005.
Fixed-rate mortgages aren't the bargain they once were, with rates on 30-year fixed-rate loans currently averaging 6.26%, up from as low as 5.37% in June 2003, according to HSH Associates, financial publishers in Pompton Plains, N.J. But these loans are still relatively cheap by historical standards. In addition, because the yield curve has flattened, borrowers don't have to pay much more to protect themselves against rates moving higher.
For many borrowers "fixed-rate mortgages make relatively more sense right now than they did even last year because the alternatives are pricey by comparison," says Keith Gumbinger, a mortgage analyst at HSH Associates.
HYBRID ADJUSTABLE-RATE MORTGAGES
Hybrid ARMs combine the security of a fixed-rate loan with the savings of one with an adjustable rate. The interest rate on these loans is typically fixed for the first three, five, seven or 10 years. After the fixed period ends, the rate adjusts annually.
But thanks to a flatter yield curve, the benefits of taking out a hybrid ARM are smaller than normal. Rates on a "10-1 hybrid," which carries a fixed rate for the first 10 years and then adjusts annually, currently average 6.26%. That's the same as the rate on 30-year fixed- rate mortgages.
Borrowers can lower their rate by choosing an ARM with a shorter fixed period. Rates on a hybrid ARM that's fixed for the first seven years currently average 6.07%. That's 0.19 percentage point less than the rate on a 30-year fixed-rate mortgage, and less than half the savings borrowers normally get for picking this product. With a hybrid ARM, "you're taking on some risk, but getting very little reward," says Mr. Gumbinger.
Still, a hybrid ARM can be a good buy for homeowners who plan to move within a few years. Borrowers are typically advised to tie the length of the fixed period to how long they plan to stay in a home. Someone who plans to move within five years, for instance, might opt for a loan that carries a fixed rate for the first five years.
But with the gap in rates narrow to nonexistent right now, borrowers may want to consider taking a conservative stance -- picking a hybrid that has a fixed rate for seven years even if they expect to move in five, or choosing a fixed-rate loan over a 10-year ARM. "It's one of the ways to protect yourself from the uncertainty of what might happen in the housing market," says Greg McBride, a senior financial analyst with Bankrate.com, a provider of financial rate information in North Palm Beach, Fla.
SHORT-TERM ADJUSTABLE-RATE MORTGAGES
Short-term ARMs, which reset every year or even more often, typically carry the lowest rates because they carry the highest interest-rate risk. But with a flat yield curve, borrowers aren't getting that big of a break to compensate for the chance that their monthly payments could soon jump higher.
Rates on ARMs that are fixed for the first year currently average 5.39%, according ot HSH Associates, roughly one percentage point less than the rate on a comparable 30-year fixed-rate mortgage. Given where interest rates are today, someone who took out a one-year ARM could expect to see the interest rate on the loan jump to 7% in 2007.
Because the savings are so short-lived, these ARMs aren't likely to make much sense for many people. But they could hold some appeal for borrowers who expect their income to move higher or for people willing to bet that rates are near their peak and will soon begin declining -- provided they can afford any increase in monthly payments.
INTEREST-ONLY MORTGAGES
Interest-only loans allow borrowers to pay interest and no principal in the loan's early years, which makes them a favorite with people looking to reduce their monthly outlays. Most interest-only loans carry adjustable rates. But in recent years, many lenders have begun offering fixed-rate mortgages with an interest-only feature.
But these loans have significant drawbacks. Rates tend to be about one-eighth to one-quarter of a percentage point higher than rates on traditional mortgages. In addition, borrowers can face sharply higher payments down the road when the interest-only period ends and the monthly payment resets so that the loan can be repaid over the remaining term.
To get a sense of the potential pain, consider a borrower who takes out a $200,000 fixed-rate mortgage with a 6.5% rate that's interest- only for the first 10 years. In year 11, the monthly payment will jump to $1,491 from $1,083, a 38% increase, according to HSH Associates. The increase would be even higher if the rate on the loan also adjusts when the interest-only period ends.
Still, interest-only mortgages can make sense for borrowers whose incomes fluctuate and those who are stretching to afford a more expensive home, says Jack Guttentag, a professor of finance emeritus at the University of Pennsylvania's Wharton School in Philadelphia who runs a mortgage-advice Web site, www.mtgprofessor.com. These mortgages also can be a good choice for borrowers who expect their income to jump in coming years, making it easier to handle any increase in monthly payments.
OPTION ADJUSTABLE-RATE MORTGAGES
Borrowers have flocked to option ARMs for their rock-bottom introductory rates, which can be as low as 1%. These loans give borrowers multiple payment choices: typically a minimum payment that's set at the start of the year, an interest-only payment, and the standard payment on a 15-year or 30-year mortgage.
But option ARMs have lost much of their allure as short-term interest rates have moved higher. Some lenders have raised the teaser rate, used to set the minimum payment during the first year, and boosted other charges for new borrowers.
Rising short-term rates also are bad news for borrowers with these loans because they translate into a higher interest rate on the loan once the teaser period ends. A borrower with an option ARM might pay 6% or more today -- not much of a saving over a 30-year fixed-rate mortgage -- compared with roughly 4% in mid-2004, according to HSH Associates. The rate on the loan will continue to move higher to account for increases in short-term rates.
Option ARMs also have caught the attention of regulators, who worry that many borrowers don't understand their risks. Chief among them: Borrowers who make the minimum payment on a regular basis can see their loan balances grow, which is known as negative amortization.
In addition, borrowers can face sharply higher payments down the road. That's because lenders typically limit the amount the minimum payment can rise in most years. But that limit is lifted once every five years so that the borrower is put back on track to pay off the loan over the remainder of the 30-year term. The limit also is lifted if negative amortization boosts the balance on the loan above a preset level, usually 110% to 125% of the original loan amount.
The worry is that some borrowers won't be able to handle the payment shock. Assuming rates remain stable, borrowers who make the minimum payment could see monthly payments jump by more than 50% at the start of year six, according to federal bank regulators. If rates go up by two percentage points, monthly payments could nearly double.
As a result, these loans make the most sense for those who earn large bonuses or have irregular income, not for borrowers who plan to regularly make minimum monthly payments.
FORTY-YEAR MORTGAGES
A growing number of lenders have begun offering mortgages with 40- year terms as an alternative for borrowers looking to lower their monthly payments. But these loans can be costly over the long run.
Rates are typically one-quarter of a percentage point higher than rates on comparable 30-year mortgages. Borrowers also pay more interest over time because the loan is stretched out over an additional decade.
A borrower who takes out a $200,000, 40-year mortgage with a 6.25% fixed rate will pay $345,000 in interest over the life of the loan, according to Bankrate.com, compared with about $243,000 in interest for the same loan with a 30-year term. If the rate on the 40-year loan is 6.5%, the total interest payments jump to $362,000.
What's more, the reduction in monthly payments can be quite modest. A borrower with a 6.25% 40-year loan would pay $1,135 a month, according to Bankrate.com, just $96 less than the monthly payment on the comparable 30-year mortgage. If the 40-year loan carries a 6.5% rate, the monthly payment is just $61 lower.
"I think they are a very bad buy," says Prof. Guttentag. "Given the rate difference, you'd be better off with an interest-only mortgage."
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Ms. Simon is a staff reporter in The Wall Street Journal's New York bureau. She can be reached at ruth.simon@wsj.com.
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