The rise in interest rates hasn't seemed to dampen the home buying market, but it is throwing a wet blanket over refinancing.

Before you jump up on the fence hoping for rates to come back down, don't overlook alternative financing options that help make financing more affordable.

Fixed interest rates resumed their upward trend the week ending Aug. 21 as the Freddie Mac Primary Mortgage Market Survey average rose to 6.28 percent. Rates had fallen the previous week, taking a breather from seven consecutive weekly jumps since the record low 5.21 percent on June 19.

Down shifted refinancing activity prompted the Mortgage Bankers Association of America to switch gears on origination forecasts for refinance loans now expected to fall off by 8 percent from initial expectations.

As buyers continued to purchase homes at record levels and new home builders remained bullish, estimates for purchase-loan activity remained unchanged.

As rates have risen, some buyers have begun to consider financing alternatives, like adjustable rate mortgages and interest-only loans -- both of which make qualifying easier.

The ARM Alternative

Right now, an ARM's interest rate will give you a mortgage that, on the average, will cost you hundred of dollars a month less on a $250,000 mortgage than you'll pay with a fixed rate mortgage (FRM). Almost two and a half percentage points separate the average FRM from the average 1-year ARM, which was at 3.84 percent Aug. 21 according to Freddie Mac.

That lower monthly payment could allow you to qualify for a loan you otherwise couldn't afford or allow you to qualify for a larger loan, but you'll have to be prepared for the adjustable end of the ARM.

When the first adjustment occurs (typically from six months to one, three, five, seven and 10 years), how often the rate adjusts, and how it can go with each adjustment and over the life of the loan, depends upon the loan terms of the loan.

Because they begin so low, most adjustments do move the rate up.

"If you know mortgage rates will stay the same or fall forever; if you know mortgage rates will stay the same or fall for as long as you have the loan; if you know you will have the loan for 10, 7, 5 or 3 years and a period fixed ARM (after tax consequences) is available at a rate that's better than the 30-year fixed rate (after tax consequences) alternative," an ARM could be a good choice, said Roger Harrington, owner of Roger Harrington's Mortgage Advisory in White Bear Township, MN.

However, "If one of these factors aren't present, the only reason you should consider an ARM is if it's the only plan available to you, or if the lowest possible payment now is more important to you than a multitude of adverse consequences later, i.e. you need money to buy food now -- and you'll worry about the consequences later," said Harrington.

As Harrington points out, ARMs have left a lot of broken glass from frustrated crystal ball gazing.

"In the last six weeks we have been through the most dramatic increase in long-term interest rates in almost twenty years. If those who claimed any proficiency in prediction had any real ability, you'd think that someone would have predicted it. But I defy you to go back through the business publications and find anyone who predicted this one," said Newport Beach, CA-based Randy Johnson a mortgage broker, author of How to Save Thousands of Dollars on Your Home Mortgage, (John P. Wiley, $14.95) and publisher of the Savvy Borrowers Web site.

The Interest-Only Option

Some borrowers are turning to interest-only loans for the same reason they go for ARMs, lower monthly payments.

"With the reduced monthly cash flow, if there is no prepayment penalty, you can pay extra to bring down the loan balance, while affording a more expensive home in the qualification process," says Greg Haas, a real estate investor and broker owner of Real Estate Investment Counsel in Milpitas, CA.

Despite their name, the loans are not principal free, rather, the loan's terms permit you to make monthly interest-only payments -- for a period. During that period, of course, the loan balance doesn't shrink.

The interest-only period is typically 5 to 10 years and at the end of that period the loan converts and your monthly mortgage payment is raised to the fully-amortizing level. The new payment will be larger than it would have been if it had been fully amortizing when you first signed for the loan. Some interest-only loans never convert, and, at the end of 30 years, demand a balloon payment for the principal balance.

You'll have to have the money for the larger payment or the balloon payment or be qualified to refinance the loan. If you can't hack it, you could suffer not only the loss of the property, but also a serious credit report ding.

Also, your home may appreciate in value, but your equity gain will be zero during the interest-only period. That may not matter in steadily appreciating markets like California, New England and elsewhere.

"I would advise a client to do interest-only over adjustable if they can not qualify for a standard 30-year. The consumer can qualify for about 15 percent more house on an interest-only. The appreciation on the 15 percent extra purchase price more than offsets the lack of principal reduction that is lost most of the time," said Richard Calhoun, broker-owner of Creekside Realty and real estate investor in San Jose, CA.

"The only time it doesn't is if homes are appreciating at less than 1.5 percent per year. If the appreciation is less than 1.5 percent, the consumer should not purchase anyway," said Calhoun.

Published: August 29, 2003

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A journalist for 35-years, Broderick Perkins parlayed an old-school daily newspaper career into a digital news service offering editorial content and consulting services. Perkins' San Jose, CA-based DeadlineNews Group includes the flagship news site, DeadlineNews.Com, offering real estate, personal finance and consumer journalism, and a backshop, the Deadline Newsroom.