Commentary

For many adjustable-rate mortgage borrowers the New Year started with good news: The 11th District Cost of Funds Index, an index used for many ARM loans, dropped to the lowest level seen in 20 years -- 3.368 percent. If you have an ARM with the 11th District COFI plus a margin of 2 percent, your new rate will be 5.368 percent.

The first week of 2002 seemed otherwise uneventful on the mortgage front. There was little news, one way or the other, and the trends in place before the New Year continued. Unemployment climbed, manufacturing was slow, and time has passed since the last Fed short-term rate reduction.

"For the markets," says HSH Associates, a leading financial publisher that checks rates with 2,000 lenders each week, "it was another week broken up by a holiday, but not one without important economic data. To some, the tone of the data suggests an emerging recovery, but to us, it simply looks like a better grade of recession."

And that is the dilemma: Are we on the verge of a recovery or is the recession hanging tough? You can get economists and seers to affirm either side of the question.

The real estate sector has certainly done well: Interest rates have been low for the past year, especially during the summer, and it may be that 2001 was a record year for existing home sales.

Will rates rise if there is an economic recovery?

Quite possibly. The reason is that when the economy expands there is more competition for money as businesses seek financing to grow. More competition for dollars generally translates into higher rates for mortgage loans.

The catch is that the recession is plainly not over. Maybe it will end in a few months, but then maybe not. Until the economy turns, rates are likely to stay about where they are, a level which should be attractive to those buying and refinancing.

Notes

• Thirty-year, fixed-rate financing with 20 percent down, a conventional loan, consists of a mortgage with 360 monthly payments of equal size and an interest rate which remains constant throughout the life of the loan. At this time, conventional fixed-rate loans of up to $300,700 are available in the lower 48-states. In Hawaii, Alaska, Guam, and the U.S. Virgin Islands the loan limit for fixed-rate conventional financing is $451,050.

• Fifteen-year, fixed rate financing has a larger monthly payment than a 30-year loan, but lower interest rate and a smaller potential interest cost. Example: Suppose that the current interest rate for a 30-year fixed-rate conventional mortgage is 7 percent and the interest rate for a 15-year loan is 6.80 percent. For a $100,000 loan, the 30-year borrower would pay $665.30 per month for principal and interest. The total interest cost over 30 years (360 payments) would be $139,508. For the borrower who tales out a 15-year fixed-rate loan for $100,000, the monthly cost for principal and interest would be $887.68. Over 15 years (180 payments), the total potential interest cost would be $59,978.

• A jumbo loan is, essentially, a 30-year mortgage but with a loan amount above the conventional loan limit, in this case $300,700 for a single-family home in the lower 48 states. Because a larger loan amount is outstanding, lenders have more risk and so interest rates are somewhat higher than for conventional financing.

• An adjustable rate mortgage (ARM) is a form of financing which typically has an initial "start" rate lasting six months or a year, and then rates which change on a regular schedule. Because the interest rate changes, monthly payments can also rise or fall. The interest rate changes are based on an index not controlled by the lender such as the average price of Treasury bills over six months or a year, loans made by the Federal Home Loan Bank in San Francisco to lenders in California and Nevada (what's known generally as the11th District Cost of Funds Index), and the LIBOR rate (the London Interbank Offer Rate, a measure which relates to the cost of borrowing in Europe).

  Most ARMs have annual and lifetime interest caps, and also annual and lifetime monthly payment caps. Some ARM mortgages allow lenders to collect "negative amortization," an expression which means the interest cost is greater than the monthly payment, so the size of the debt increases.

• Interest rates are calculated at a given percentage of the loan amount per year, say 7 percent annually. A basis point is equal to 1/100th of 1 percent. Thus if a loan interest rate moves from 6.60 percent to 6.65 percent, it has gone up .05 percent or 5 basis points.

• Loans have a nominal interest rate, say 7 percent, and an annual percentage rate (APR). The APR is important because it includes not only the interest rate, but also such costs as points (loan discount fees), per diem interest, mortgage insurance and other expenses.

• The major reason that mortgage interest rates go up and down relates to the matter of alternatives. Investors can put money in the stock market, bonds, real estate, commodities, and other options. Their choice will be determined by such factors as risk, the rate of return, and the potential for appreciation.

  In particular, when bonds become more popular, when more people want bonds, prices go up. When bond prices rise, yields go down. Yields for 10-year bonds relate somewhat to mortgage rates because mortgages are typically paid off within 10 years.

  As an example, imagine that you can buy a $1,000 bond that pays 5 percent interest. A week from now the price of your bond rises 10 percent. The bond is now worth $1,100 if you sell.

  Now let's look at the other side of the transaction. When the bond was bought for $1,000 the investor received $50 per year -- a 5 percent interest rate. If the value of the bond increases to $1,100 and the interest payout is the same, $50 per year, the yield then declines to 4.545 percent.

  You can also work the system in the other direction. Imagine that the value of the bond fell to $900. It is still paying $50 in annual interest. When the cost of the bond is $900 and the pay-out is $50, then the yield -- or interest rate -- rises to 5.555 percent.

  So when bond prices rise, interest rates fall. And when bond prices fall, interest rates rise.

Be aware that the rates presented here may not reflect the rates for individual loan products at any given time, and that rates are constantly in flux. For additional information regarding current mortgage rates, please consult the Bank Rate Monitor or your local lender.

Published: January 7, 2002

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