Remember Limbo, that party game where revelers take turns ducking under an ever-lower bar? You may not have the knees to be a Limbo star, but with interest rates dropping rapidly, you may be asking yourself `How low can they go?' To win the interest rate game, there are moves you should make and others you should definitely avoid. Here are some guidelines.
Home Sweet Home
You've heard it before: Now seems like a great time to refinance your home. If you're about to skip this paragraph because the rates available aren't two percentage points below your existing rate or because you've recently refinanced, wait! Experts say the 2 percent rule isn't necessarily the best benchmark. In the past, a 2 percent reduction was necessary to cover refinancing costs. In some cases, the lender also charged "points," with each point amounting to 1 percent of the loan amount. But as interest rates have fallen, policies have changed. Today, because of high levels of consumer debt and increasing competition from home equity lenders, banks and mortgage brokers are offering homeowners better deals.
To get the best deal, be skeptical of offers that tout no out-of-pocket costs. Fees are often included in the total amount borrowed, meaning you pay those fees, plus interest, over the life of the loan. It may be more prudent to pay points upfront. "Points should be considered if you're going to live in your home for more than five years because by the sixth year, you'll recoup the upfront fee you'll pay in points through savings on the monthly payments," says Suzanne Bach of IPI Financial Services in New York City.
Say the amount you want to borrow is $250,000, and you can get a 30-year mortgage at a 7 percent rate with no points. Your monthly payment is $1,663. With one point, the rate drops to 6.75 percent for a monthly payment of $1,621. The difference in payments is $42 per month. If you're paying $2,500 extra for the one point upfront, how long will it take to recoup? Divide the cost of the point by the difference between the loan amounts. The answer is the number of months it will take to make up the cost of the point. In this case, it'd be about 60 months. If you're considering paying more than one point to get an even lower rate, Bach notes it will still take about five years to make up the difference, but after the 60th month, your savings will be $42 per month. Plus, in most cases, points paid at closing are tax-deductible. Consult your tax advisor.
Once you've decided on the points-or-no-points issue, there's still the term of the loan to consider. When determining what duration is best for you, consider the difference in interest rates and the amount of your monthly payments. If you think rates are as low as they're likely to go and you plan to stay in your home for a while, most experts suggest a 15-, 20- or 30-year loan.
Payments on a shorter loan may not be as daunting as you think. If you're comparing a 30-year loan at 8 percent to a 15-year, 6 percent loan, you'll be increasing your payments not by half but by about one-third while halving the length of your mortgage. If the idea of a big fixed monthly expense scares you silly, a longer-term mortgage makes sense, if not dollars. After all, you can always make additional principal payments to shorten the length of your 30-year loan, but you can't stretch out payments on a 15-year mortgage. Experts advise exercising caution if you're considering a short-term variable loan because you plan to move in a few years. Rates are low now, but if you stay longer than you planned, you could be in for a shock when your mortgage rate resets or when you look for permanent financing later.
Recently refinanced and don't think it's worth the hassle of doing all that paperwork again? Consider this: If you invested $200,000 in a bank and the one across the street offered you 1 percent more interest, would you consider moving your money? Of course you would, depending on what the move would cost. Figure out how long it would take to recoup the costs of the loan before you rule out refinancing again. Lenders are competing for qualified buyers, so take advantage of their largess . . . and today's low rates.
Before shopping for loans, consider one more option: staying put. Your current mortgage holder probably won't require a credit check, land survey or title search, and this can save you money on closing costs.
Pay As You Go
Congratulations! You've refinanced your home and have a little extra in the bank each month. Before you start dreaming of the new shoes or computer you're going to buy, look at your credit card balance. If you have one, now's the time to get rid of it. Unlike other forms of interest that have dropped as yields on Treasury bonds have fallen, credit card companies still charge outrageous rates.
Think of it as the only way you can get a guaranteed return of 15 percent or more without any risk. So take that extra money and apply it where it counts the most. When your cards are paid off, reward yourself . . . just don't put those Ferragamos on your Visa.
Low interest rates may be great for homeowners, but they're less desirable for those seeking safe havens for their money. Rates on certificates of deposit are nothing to write home about, so many income-oriented investors are looking for other ideas. While some pundits recommend Treasury bonds with 30-year maturities, you might want to take a shorter-term view. To get the most out of fixed-income investing, consider bonds with maturities of no longer than seven to 10 years so you'll have the chance to get a high yield without tying up your money for an additional 20 years.
If you're OK with investing in securities that aren't backed by Uncle Sam, look into adjustable-rate securities. These can follow the yields of many types of securities, but most adjust based on the highest yield of the three-month, 10-year or 30-year Treasury bond. Rates remain in place for one quarter or more, and there are minimum and maximum yields to which the dividend can be reset. When interest rates rise, investing in this type of security means you aren't stuck with low rates.
Trying to hit a moving target may not be for you. If it's not, consider a laddered portfolio of securities with different maturities. Investors with $50,000, for example, could buy one issue and hope rates go their way, but investing this sum in five blocks of $10,000, with one coming due each year for five years or every other year for 10 years, might make more sense with today's low interest rates. As portions come due, they can be reinvested in securities that take advantage of current market conditions.
Don't limit your thinking to just one type of security, either. Mix and match with corporate and government bonds or preferred stock--whatever provides the best return for your comfort level.
If you know the rules of the game, today's low interest rates can be a great opportunity for investors, savers and spenders alike.
IPI Financial Services, 120 W. 45th St., New York, NY 10036, (212) 354-2525 ext. 235
Lorayne Fiorillo is a financial advisor at Prudential Securities Inc. Past performance is no guarantee of future returns. For more information, write to Lorayne in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614.