SANTA CRUZ (June 22, 2008) - As is customary, mortgage rates have been on the move. Homebuyers in escrow and homeowners considering refinancing have watched the rates in their seemingly relentless march upward. After all, just a month ago, 30 year fixed rates for loans of $417,000 or less were available for 5.5 - 5.75 percent. This week, those rates reached 6.5 percent.

Nothing influences long term mortgage rates more than the prospect of inflation. When the cost of consumer goods increases, the value of the dollar declines. In order to guard against this decline, mortgage interest rates must go up to compensate.

The index that is watched most closely is the core Personal Consumption Expenditure index (PCE). This is a measure of the cost of services and goods sold without taking into account the rise and fall of energy and food prices. The Fed’s target for the PCE is 2 percent or under and right now it is climbing slightly above 2 percent. In response, many economists are predicting that the Fed will start increasing the Fed Funds rate at their meeting at the end of August. Theoretically, this change in Fed policy would serve to slow down inflation and cause long term mortgage rates to decline.

Homebuyers have some options to mitigate the prospect of higher mortgage payments. A popular option is to obtain a mortgage that allows the borrower to just pay the interest. Since rates are slightly higher when there is the option to pay just interest, I am going to use 6.875 percent as an example. The interest portion of a 30 year fixed rate mortgage at 6.875 percent accounts for about 87 percent of the full principal and interest mortgage payment. The interest only payment at this rate would be equivalent to the principal and interest payment on a 30 year fixed rate mortgage of about 5.6 percent.

Another way to lower rates (thus, lower the payments) is to pay more points in exchange for a lower rate. In this market, the seller may be willing to pay 3 - 6 percent of the sales price to the buyer as a sales concession. This money may then be used by the buyer to lower the rate.

Alternatively, the homebuyer may choose to close escrow now but wait until rates dip again to grab a lower rate by refinancing. If this is the case, minimizing the closing costs by selecting a higher rate may be today’s best option. The savings in closing costs at purchase may then be applied to the closing costs for a refinance.

Accepting an adjustable rate mortgage will also serve to keep the mortgage payments down. For example, the HomeOwnershipAccelerator loan (see my archived Sentinel column on this loan program on my website at www.PeterBoutell.com) has an initial rate today as low as 3.25 percent. Or, a hybrid ARM that is fixed for the first five years offers lower payments than 30 year fixed rate mortgages and provides payment stability for the first five years.

Also, let’s not lose sight of the fact that a rate under 7 percent is historically a great rate!

This column is written every Sunday by Peter Boutell, Certified Mortgage Planner and a principal at Santa Cruz Home Finance. You may reach him at (831) 425-1250 of email him at Peter@SantaCruzHomeFinance.com.