Adjustable rate mortgages: why do it?

Discussion in 'Archived Threads 2001-2004' started by Brett_H, Dec 30, 2002.

  1. Brett_H

    Brett_H Second Unit

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    We're continuing down the road to buying our first home, and the one thing that really confuses me is why in the world anyone would go with an ARM in the current climate. With interest rates as low as they are, what's the incentive? Seems to me that they've got nowhere to go but up...

    Are banks trying to steer people in this direction by using their credit rating against them? Meaning, if you have less than perfect credit, are they going to try to get you to go with an ARM by making the APR for a fixed-rate artificially high? The only reason I can think of to go with one is that they might offer a low enough rate to make a payment affordable now; but if that's the only thing that would make the payment affordable, then you're going to be screwed when the rates start to move up, right?

    If someone could explain this one to me I'd really appreciate it!

    Thanks,
    -Brett.
     
  2. Marc S Kessler

    Marc S Kessler Stunt Coordinator

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    An ARM is advantageous to people who know that they will only stay in the property for a short time. In those cases it really pays to get an ARM.
     
  3. Danny R

    Danny R Supporting Actor

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    Yup, with a low initial interest rate, you are paying much less interest and putting more toward the equity of the house. If you are planning on selling in a few years, thats a much better deal than a traditional 30 year mortgage.
     
  4. Jay Taylor

    Jay Taylor Supporting Actor

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    Brett,

    There are also other options than an ARM or Fixed. We once had a 7-year ARM, which means the first 7 years was fixed & then it went variable for the remainder of the 30-year mortgage.

    We chose this option because we knew we were going to have the house paid off in 7 years and it was a lower rate than fixed. It wasn't as low an interest rate as an ARM but it was lower than a fixed and we knew the rate wouldn't go up for 7 years.

    Depending on your mortgage company you can get 3-year, 5-year, 7-year, and 10-year ARMs with the total loan being typically 30 years.

    Jay Taylor
     
  5. Jeff Ulmer

    Jeff Ulmer Producer

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    I have a below prime variable rate, and it is saving me thousands every year. The percent spread between the floating rate and fixed rate is more than enough to justify any potential risk. The rates would have to near double before you'd be paying more interest, and by that time your principle has been lowered enough so that you again are still saving money, even at a higher rate.

    I also try to lower my amortisation period with each renewal. Changing from a 30 to a 25 year term doesn't cost much more per month, but shaves more thousands in interest off the loan, especially in the early years when the ratio of interest to principle is higher.
     
  6. Bernie Lomax

    Bernie Lomax Agent

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    I have a 3/1 arm. I had a 3/1 at 5.875% and just refinanced after only 6 months for a 3/1 at 4.875%. It saves me about $125 a month. I won't own my place for more than 3 years, but if I did keep it to rent or whatever I can refinance at any time.
     
  7. Brett_H

    Brett_H Second Unit

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    Jeff,

     
  8. Jeff Ulmer

    Jeff Ulmer Producer

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    I am talking about a variable rate, which is tied to (and always below) prime. I have saved about a 3% spread between a fixed rate and variable rates since I got my mortgage.

    First, you have to seperate the amortization period from the mortgage. This is the number of years it will take you to pay off the mortgage. Keep this as short as possible, since every additional year adds more interest onto the loan.

    The term of your mortgage can range from 6 months to 20+ years, and is the time affected by a fixed rate. The longer the term, the less flexible, generally.

    It doesn't really matter how long you intend to keep the property, since the goal in borrowing is to incur the least amount of interest, while also gaining the most equity. If you sell, you have to pay off the mortgage in its entirety anyway (in most cases). All a fixed rate does is make sure you aren't paying any more than that rate, should rates go up.

    Lets look at two mortgages which are identical in all but the interest rate. Both are for $100K, 30 year amortization, 5 year term.

    1. Mortgage #1 is at 5%. Monthly payments would be $533, for a total of $31,980.00. At the end of the term, you would still owe $91,761.76.

    2. Mortgage #2 is at 6%. You would be paying $594/mo for a total of $35,640.00, and you would owe $92,969.49.

    That 1% difference over 5 years costs you an additional $3,660 in payments, plus costs you another $1200 in equity for a total difference of $4860.00. That's almost an extra $1000 per year for just a 1% difference in borrowing rates.

    In order for the floating rate (which may not be the same as an "adjustable rate") to actually cost you more, the prime interest rate has to climb dramatically to offset the difference. Since you are paying off your loan (ie gaining equity) at $1000/year more on the lower rate, even if the rates went up, you would be borrowing on a smaller principle. If you are talking about a fixed rate over the same period, it works the same. You save $4000 in payments and interest at the lower rate, which means the rate after the fixed term has to go up substantially to actually cost you anything.

    With my mortgage, the payments are fixed, even though the rate is variable. If the rates go up, the amortization becomes longer to fit the payments, if it goes down, the principle is paid off faster, so the amortization period decreases. At no point am I forced to sell the house because of changes in the payments - I just have to pay for a longer period of time in a worst case scenario.

    A couple of other things to consider in a mortgage are what penalties are incurred if you decide to change things during the term. Most mortgages have penalties for early payoff (selling the house), changing rates (if possible), converting to a different type of mortgage (ie fixed to variable, changing amortization, etc.). Also, many mortgages have prepayment options (ie make a lump sum payment against the principle) or missed payment options. You also have a choice of payment frequency, which can also lower your overall interest - the more frequent the payments, the faster your principle is paid down.

    Most financial institutions should have an online calculator that lets you run through different scenarios for comparison. The numbers I gave above were using one of these.

    Lets look at these two mortgages again, but now use the calculator to see what happens if you were to make the same payment per month on both, but with the same 1% spread. We already have the numbers at 6% above.

    At 5% and $594/month, your mortgage would be paid off in 24 years - saving you 6 years of payments over the same monthly payment at 6% = $21,384. Mortgage #1 would leave you owing only $87,665.67 at the end of 5 years, an increase in equity of over $5300, for exactly the same cost to you.

    The moral is, paying less interest is better!
     
  9. Ashley Seymour

    Ashley Seymour Supporting Actor

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    This question pops up from time to time and may be in archive.

    One other reason to consider and the main one in my opinion, is that an ARM is advantageous if you have a monthly expense that will go away in the near term, but that prevents you from getting a higher mortgage now. That $100,000 mortgage at the ARM rate would equate to about an $85,000 mortgage at the fixed rate. Depending on your area, that is an extra bedroom, half a bath, second car garage, couple of hundred square feet, and combinations of the above. If you are paying for child care, student loan, or something that will go away in a few years you will have more money to spend on housing. This assumes that ARM rates would go up on the worse case scenario.

    What often happens is that the couple who buys the $85,000 mortgage will outgrow the house, sell it and buy that $100,000, (or by now $105,000) mortgage. But the costs to sell and buy will eat up $$8000-10,000. That cost seems to me to be way more than the worst case ARM mortgage payment going to the max.

    If you don't have expenses that will go away, then one of the other main reasons is that you have considered a shorter term mortgage, say a 20 or 25 year mortgage, and can afford a higher payment. Get the ARM loan with the lower rate and make the payment for the 20 or 25 year loan. You would just designate a higher level of principal payment.

    Reason three, is that you are speculating and think short term rates will stay down. This is a gamble and I would never advise it. That said, I have a VA ARM with a 2 point spread over the 6 month t-bill that adjusts twice a year. It has a 5 point cap with a max at 11%. It is now around 5.875% and in February will drop even more.
    What is the future of interest rates? With a weak economy, I would hardly bet that they are up over the next year or two. If anything, they may take further drops. We are facing a bear market and an economy that will take a lot of stimulation before rates go up. I doubt Greenspan will ever raise a rate again. As a gamble, I will bet rates will stay down.

    Jeff

    Check your calculator. You appear to be using Anuity tables. For loans the Anuity Due feature is used. The 5% payment on a $100,000 loan is $534.59 and for 6% is $599.50.
     
  10. Jeff Ulmer

    Jeff Ulmer Producer

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    Ashley, I was using the Mortgage calculator at Webfin
    For the example I was using a 30 year amortization, $100K principle, 5 year term, monthly payments, and 5 and 6% interest rates. Numbers were rounded for simplicity.
    One other thing that was brought up by that investment advice lady on TV was NOT to have the bank also take your property taxes with each mortgage payment, but rather to save for those seperately. Since your taxes are due only once a year, prepaying just allows the bank to earn interest on your money.
     
  11. Brett_H

    Brett_H Second Unit

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    Jeff,

    A couple further questions on some things you said, if you don't mind.

     
  12. Joe McKeown

    Joe McKeown Stunt Coordinator

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  13. Jeff Ulmer

    Jeff Ulmer Producer

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  14. Ashley Seymour

    Ashley Seymour Supporting Actor

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    Ashley, I was using the Mortgage calculator at Webfin
    Jeff,
    I checked that site and they indeed calculate the payment you quoted. But it is not the one my calculaters give. Is this a Canadian site? Or is there some other reason for the payment being so low?
    Every financial calculator I have used always gives a payment within a penny or two. I guess they differ in how many decimal places they carry out the payment. The payment factor I have used for 6% mortgages is .00599550. If you carry it out to 8 places you don't loose pennies off the calculation for mortgages up to a million dollars. For a quick ballpark calculation you can use .006 times any loan amount.
    You can use MS excell spreadsheet to do mortgage calculations to check your work. Even the little cards that mortgage lenders sometimes give will get you close.
    I just checked on webfin.com and got the same payment as my Handspring Visor calculator.
     
  15. Eric_L

    Eric_L Screenwriter

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    You Said
    "I know that it is better to take out the shortest loan that you can afford, as you'll be paying less total interest over the life of the loan"

    I would strongly disagree. There are PLENTY of good reasons to get a long term mortgage.

    First) 90% or more of mortgages never make it past their 84th payment. Due to sale or refinance. So all that cash you paid into your house is just 'sitting' there. Yes, sitting, just like it was in a cookie jar. The equity your house will build over that period should considerably outstrip your menial principal payments, even on a 15yr.

    second) Depending on your tax bracket, the government is paying up to 39% of your mortgage interest for you. Yes, your mortage is subsidised in the form of tax deductions! At the highest tax bracket that would mean a 6% mortgage would have an actual cost of only 3.66%. Why would you be in a hurry to pay that back? Use your head; you can get a very nice tax free bond that pays much more than 3.66%. Corporate bonds and many stocks have dividends above this level as well, some by a large margin. Why would you put cash in a 'cookie jar' when you could get a better return AFTER TAX on even very conservative investments? Got a thing against making money? I know some people who mortgage their new homes even when they have the cash. They then put the cash in a 30 yr bond, which pays enough interest to cover their P+I payments. At the end of 30 yrs they end up with a F+C house AND their principal from the bond! There are always the paranoid waco's who will tell you you need a F+C house because the economy is going to hell next weekend or thereabouts. They've been saying that for decades. I've yet to see hellfire flames burning Greenspan's hiney. (though at times it is an appealing thought)

    third) You can pay principal on your loan anytime. There is no reason to strap yourself down to larger payments. If you ever have a tight month financially, the 30 yr wont eat you up like a 15 yr payment would. Also, a ARM reamortizes each time the rate changes, so if you have been paying down the principal, the payment will decrease, even if the rate remains the same.

    fourth) The minor difference in interest rate may seem enticing, but you will qualify for a much larger loan with a 30 yr that you can pay down early if you choose. If you plan to live in this house for any period, you want to get as much house as you can afford in as nice an area you can find. Remember, your mortgage P+I are fixed, but inflation will change. that $2000 payment today will be a drop in the bucket in 20 years. Doubt me? Just ask your parents what their house payment was 20 years ago! Back then it seemed like alot, but in TODAYS dollars it is ridiculous cheap! If they still own the house and haven't refinanced, that is STILL their payment!

    Does this mean that paying off a loan is bad and all homes should be mortgaged? Of course not. However, it is NOT a financial neccesity. I consider a F+C house to be a luxury, like a sportscar or a fur coat (kiss off PETA!)If you can afford these things, and you want them, the go for it! If haveing that piece of paper in your hands makes you feel more secure, then get it. But ONLY if you can afford the lost tax deduction from the loan and income that the principal would otherwise create.

    I would suggest that before you commit to extra P+I payments you max out your 401k, IRA, SEP and/or whatever else you got. Get the college accounts for the kids started, and maybe a spare account for any deficiencies that these others may not cover. Of course, HOW you invest those accounts is a whole new issue, best discussed with your investment advisor.

    Oh, and back to the ARM question, it too is a matter of perference and need. An ARM will help you qualify for a larger loan and you will likely pay less if you live in your house less than 7 years. It is also good if you plan to make principal payments because of it's reamortization feature. I would not look for rates to increase for years. However, they eventually will. Be cautious buying an ARM, watch the spread and the index. It can be confusing and you can get hozed if you're not careful.
    good luck!
     

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