Cashing In on Lower Rates

Interest rates are going up — probably not within this year, maybe not even in the next. But at some point in the upcoming 24 months, says Larry Washington, Managing Director and Head of Merrill Lynch Home Loans^TM, the rates for home mortgages and other loans will likely start to rise from their current historic lows. "It's inevitable," according to Washington.

For anyone who owns or is in the market for real estate, this combination of record low rates and all-but-certain hikes on the horizon may create a rare opportunity to optimize borrowing costs and, ultimately, the value of investments. "We believe that this a great time to take advantage of the current rates and prepare for the higher rates to come," Washington says.

Earlier this year, it looked as if higher rates might already be at hand. The Federal Reserve Board increased its overnight funds rate, one of the key benchmarks that helps determine the rates for U.S. loans. More (and more substantial) Fed hikes were expected to follow, but then the Greek debt crisis hit, and signs emerged that the U.S. economic recovery might be slowing. Investors' flight to safety pushed down the yields for U.S. Treasuries, another key rate driver, particularly for fixed-rate mortgages.

Still, Larry Washington is encouraging borrowers to use this added time to analyze their mortgage financing and make sure it's as well positioned as it could be. He says the strategies break down into two basic categories: "defensive" maneuvers designed to limit the impact of the eventual hikes, and "offensive" moves that may allow you to squeeze even more value out of the rates being offered now. Here are some approaches to both strategies.

Avoiding ‘payment shock'

Depending on their type of mortgage, existing mortgage holders may want to take advantage of the current low-rate environment to reduce their current monthly payments — or to guard against the potential payment shock that could result from a rate increase.

For those with fixed-rate mortgages, the issue is fairly straightforward. If their mortgage was created as recently as three years ago — when rates for fixed loans averaged more than a full percentage point higher than they do now — they may want to consider refinancing their mortgages at today's lower rates.

People with adjustable-rate mortgages, or ARMs, have other factors to weigh.¹ If they have an ARM — in which the rate is adjusted periodically (usually once a year), based on the prevailing funds rate or another major index—their best option might be simply to do nothing. Rates for one-year ARMs are now about a full percentage point lower than for typical fixed-rate mortgages. So even if rates start to move, it could be some time before the long-term benefits of locking in a fixed rate could exceed the interim savings from an ARM.

But some borrowers have another type of ARM, known as a term adjustable-rate mortgage. This mortgage has a low fixed rate for an initial period (generally 2 to 10 years), then converts to an adjustable rate tied to one of the benchmark rates plus a premium for the remaining term of the loan. The combination of that reset plus the effect of eventual rate increases should give term ARM holders concern, says Washington. "Anyone whose term is resetting over the next three years may want to consider using this opportunity to refinance at a fixed rate now."

There is also the interest-only mortgage.² Depending on the rate at which the interest-only mortgage was set, homeowners who carry these loans may consider rolling it over into another interest-only loan at today's lower rates. But there's not a lot of time left for homeowners to make this move.

Monthly payments for interest-only mortgages consist solely of a fixed-rate interest for a set period (usually 10 years), during which the principal remains constant. When the period ends, homeowners must pay both principal and interest until the loan is retired. For many homeowners, the end of the interest-only period can mean a sharp, and unsustainable, uptick in the monthly payment. For others, though, interest-only mortgages can be an effective tool for controlling cash flow and asset allocation. "Clients who already have a lot of available equity in their home like the ability to control when they pay down their principal," Washington explains. "If they get a bonus and decide to pay down their principal by $25,000, in a fixed-rate mortgage all that does is shorten the term. But in an interest-only, that reduction in principal immediately shows up the next month in a lower mortgage payment."

Freddie Mac, one of the two federally sponsored corporations that supply liquidity for the country's mortgage market, has announced that, beginning in September, it will no longer purchase interest-only loans. Its counterpart, Fannie Mae, will still buy the loans, but with new restrictions. The upshot, says Washington, is that "these loans are going to become a lot harder to get. So if you were thinking of refinancing before your interest-only period ends, you have only a very short window before the availability tightens."

Going on the offensive

There's also another way that Larry Washington has been encouraging clients to leverage today's rates. For anyone contemplating a second or retirement home, now could be a very good time to buy. "We're not necessarily calling a bottom to home prices," says Washington. Prices could still slide lower, particularly in parts of the country with a large "shadow foreclosure" inventory of homes. "But prices are low now," he says, "and interest rates are really low. And that can be a very powerful combination."