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Falling Interest Rates

Posted by  on Apr 16, 2009
 
Falling interest rates have motivated many people to refinance a current mortgage or buy a new home. Before applying for a loan, however, borrowers should determine whether a fixed-rate or an adjustable-rate mortgage would best meet their needs. If they choose a fixed-rate mortgage, borrowers also need to choose the term of their loan. Adjustable-rate mortgages typically have a lower initial interest rate. The interest rate on an ARM is tied to one of two independent indexes: U.S. Treasury securities or the cost that banks pay to borrow funds. A margin of 2 to 3 percent is added to the index rate to determine the mortgage rate for the adjustment period, the period of time for which that rate will be used to calculate the interest costs.

Because large swings in the index rate can cause substantial changes in the monthly mortgage payment, caps typically are placed on any increase or decrease that may occur during an adjustment period. Borrowers who want to lock in mortgage costs by using a fixed-rate mortgage need to consider the benefits and the disadvantages of both fifteen-year and 30-year fixed-rate mortgages.

The advantages of a fifteen-year mortgage include retiring mortgage debt more quickly and paying less interest. A 15-year mortgage usually has a lower interest rate, typically 25 to 50 basis points lower, than a 30-year mortgage. For example, compare a 30-year loan at 7 percent with a 15-year loan at 6.6 percent. On a $250,000 loan, the interest payments would total $348,769 over 30 years, but only $144,476 over 15 years, saving the borrower more than $200,000 in interest payments.

An evaluation of the two types of loans should include a comparison of the after-tax cost of making interest payments. Home mortgage interest can be a significant tax deduction. This deduction is available to all taxpayers regardless of their income bracket, provided that they itemize their deductions.

Overall, interest paid to buy, build, or substantially improve a personal residence is deductible if the debt is secured by the property and does not exceed $1.1 million. In the aforementioned example, if a person were in a combined Federal and state income-tax bracket of 40 percent, the after-tax interest savings of the 15-year mortgage over the 30-year mortgage would be reduced to $122,576.

A thirty-year mortgage will cost more in interest, even after tax deductions, this option still can be advantageous because the thirty-year mortgage will have lower monthly payments than a fifteen-year mortgage. That advantage may be important from a current cash-flow perspective, particularly if the excess monthly cash available is invested properly. Using the $250,000 loan amount, the monthly payment on a 30-year mortgage is only $1,663 compared with $2,191 for a 15-year mortgage. The difference is $528, but because a greater portion of the 30-year payment would be tax-deductible interest, the after-tax differential on the two mortgages for the initial monthly payment is $562.

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