5/1 ARM - what would you do?

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5/1 ARM - what would you do?

Postby Chan_va » Fri Feb 08, 2013 10:35 am

Folks,

About a year ago, I refi'ed our mortgage (280K) into a 5/1 ARM at 2.5%. The thinking at the time was that we would probably move into a different place in 5 years. But now, we are not so sure and may stay here longer than 5 years. Here are my options as I see them - what would you do?

1. Refi now into a 30 year fixed. Pro - locks in today's rates, cons: closing costs, 1% differential in rates
2. Wait till 2016 to refi again if needed. Pro - another 4 years of payment at 2.5%. Cons - who knows what rates will be like in 2016?
3. Aggressively pay down mortgage by 2016. Pro - debt free. Cons - does it really make sense to aggressively pay down a 2.5% loan?

Other pertinent information. 33% federal tax bracket, 6% state, 37 y/o. Comfortable emergency and savings rate. Currently directing 4k/mo into a 70/30 AA that could be used to pay down mortgage.

Thanks,

BC
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Re: 5/1 ARM - what would you do?

Postby G-Money » Fri Feb 08, 2013 11:22 am

How much longer?

If you're looking at staying there 5-10 years, I'd say refi to PenFed's 5/5 ARM with no closing costs. Initial rate is 2.625%. After 5 years, it will adjust, but no more than 2% higher (so ceiling of 4.625%), and will stay there for the next 5 years. After that 5 year period, it can rise again (again, max of 2%) for the next 5 years. Total interest rate ceiling is 6% above initial rate.

If you're looking at staying there 15+ years, get a fixed rate mortgage. Find a desirable combination of rate and closing costs at a lender like Amerisave, Aimloan, Firstib, NMA, etc. Check your local banks and credit unions, too. But, in general, I don't think the differences in rates between ARMs and fixed rate mortgages is enough to compensate you for taking on the interest rate risk.

Waiting until 2016 to decide what to do is also taking on interest rate risk. Again, the spread between ARMs and fixed isn't enough to compensate you for this, IMO.

As for whether to pay of or pay down the mortgage, be sure to read the Wiki article: http://www.bogleheads.org/wiki/Paying_d ... _investing. I'm coming around to livesoft's argument that there is additional value in the call option you have in keeping a mortgage (i.e., you can decide to pay the mortgage back at any time), which justifies keeping a mortgage even if your after-tax risk-free rate of return is lower. Plenty of threads here on the great "pay down or invest" debate.
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Re: 5/1 ARM - what would you do?

Postby Chan_va » Fri Feb 08, 2013 12:25 pm

Thanks. The timeframe for staying in this place is probably 5-10 years. So the 5/5 ARM likely makes sense.

On the pay it down debate - if you believe that the markets are efficient, the call option is built into the interest rate and expected future returns. So the call option would make sense if you are willing to take greater risk/reward than a 30 year T-note with the mortgage amount. And if you are willing to do that, couldn't you just equivalently shift your AA to include more stocks?

On the other hand, there is no efficient market in the "peace of mind" asset class.
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Re: 5/1 ARM - what would you do?

Postby G-Money » Fri Feb 08, 2013 12:44 pm

Agreed, the 5/5 ARM will likely be your best bet. Just don't let 5-10 years become 15-20. :)

On paying it down: I'm not sure I'd apply EMH so strongly in consumer finance. For example, CDs with FDIC protection are no riskier than Treasuries, but even brokerage CDs (which can be sold like bonds) pay a substantial premium over Treasuries of equal duration. Also consider the considerable variation in rates for mortgages offered by different banks; since the risk stays constant (you are no less likely to repay Wells Fargo as you are PenFed), the rate/closing costs offered should be the same. They're not. :)

Good luck.
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Re: 5/1 ARM - what would you do?

Postby RobInCT » Fri Feb 08, 2013 1:12 pm

Chan_va wrote:1. Refi now into a 30 year fixed. Pro - locks in today's rates, cons: closing costs, 1% differential in rates
2. Wait till 2016 to refi again if needed. Pro - another 4 years of payment at 2.5%. Cons - who knows what rates will be like in 2016?
3. Aggressively pay down mortgage by 2016. Pro - debt free. Cons - does it really make sense to aggressively pay down a 2.5% loan?

There's also an option 4, which is to aggressively save between now and 2016 so that when the teaser rate expires you can decide whether to pay off in full or refinance, depending on what rates look like then.

I agree about not necessarily needing to be aggressive in paying down a 2.5% loan, but it's not really a 2.5% loan. It's a 2.5% loan for 5 years, so paying it off in 5 years is not really aggressive--it's actually the only thing that would make it accurate to describe it as a 2.5% loan. If you don't pay it off in 5 years, it's no longer a 2.5% loan.
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Re: 5/1 ARM - what would you do?

Postby jsl11 » Fri Feb 08, 2013 1:20 pm

Another option would be to wait a year or so. Interest rates should stay low as long as the Fed keeps them low. They have indicated that they will not raise rates until 2015. This would give you one more year at 2.5% and you may have a better idea how much longer you will stay in the house at that time.
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Re: 5/1 ARM - what would you do?

Postby G-Money » Fri Feb 08, 2013 1:50 pm

jsl11 wrote:Another option would be to wait a year or so. Interest rates should stay low as long as the Fed keeps them low. They have indicated that they will not raise rates until 2015. This would give you one more year at 2.5% and you may have a better idea how much longer you will stay in the house at that time.
Jeff

The Fed can always change its mind.
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Re: 5/1 ARM - what would you do?

Postby Watty » Fri Feb 08, 2013 2:15 pm

3. Aggressively pay down mortgage by 2016. Pro - debt free. Cons - does it really make sense to aggressively pay down a 2.5% loan?


Some people have what they call a "freedon fund" that they save up the money in a seperate account so they can pay off the mortage if it makes sense in the future. Insteading of paying down the mortage I would keep this money invested in a seperate fund and decide what to do when you actually have enough saved up to pay off your mortage.
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Re: 5/1 ARM - what would you do?

Postby Chan_va » Fri Feb 08, 2013 2:45 pm

Watty wrote:
3. Aggressively pay down mortgage by 2016. Pro - debt free. Cons - does it really make sense to aggressively pay down a 2.5% loan?


Some people have what they call a "freedon fund" that they save up the money in a seperate account so they can pay off the mortage if it makes sense in the future. Insteading of paying down the mortage I would keep this money invested in a seperate fund and decide what to do when you actually have enough saved up to pay off your mortage.


The problem is - how do I invest the money in the "freedom fund"? If I keep it in a bank, it earns less than the mortgage. If I put it into anything riskier, what if there is a bear market right before I need to pay off the loan?
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Re: 5/1 ARM - what would you do?

Postby jsl11 » Fri Feb 08, 2013 2:46 pm

G-Money wrote:
jsl11 wrote:Another option would be to wait a year or so. Interest rates should stay low as long as the Fed keeps them low. They have indicated that they will not raise rates until 2015. This would give you one more year at 2.5% and you may have a better idea how much longer you will stay in the house at that time.
Jeff

The Fed can always change its mind.

There are risks involved with every situation. Nevertheless, it is an option. Whether or not it is a good option is a separate question.
Jeff
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Re: 5/1 ARM - what would you do?

Postby englishgirl » Fri Feb 08, 2013 2:52 pm

What are the caps on the interest rate changes? For example, mine can vary by a maximum of 2% in any one year, and 6% for the life of the loan.

Most/many/all (??? I don't know) ARMs reamortize the loan every year (or, I suppose in the case of a 5/5, every 5 years). So, paying down any principal reduces the oustanding loan balance, which is taken into account when determining your payment. Thus, if you have paid off some principal, even if the rate rises, your payment may not. Or may not rise by much. This year, my rate stayed the same (2.625%) but my payment went down because of the reduction in the oustanding loan balance.

So I would add as much money to principal as you can, and then just let the rate float IF you have a decent cap on how much the rate can float. But then, I am in the minority here. My 5/1 ARM's rate has been floating since 2009, and I have no intention of refinancing. If the rates rise, I will dump money into it to get it paid off quicker.
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Re: 5/1 ARM - what would you do?

Postby LadyGeek » Sat Feb 09, 2013 10:57 am

This thread is now in the Personal Finance (Not Investing) forum (mortgage).
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Re: 5/1 ARM - what would you do?

Postby robjer » Sun Feb 10, 2013 10:44 am

I think any mortgage that is going to have to be refinanced within 5 years is playing with inflationary fire.

You have already changed your plans in the short time since you opted for the 1/5 mortgage and so far you have been lucky mortgages have not experienced a larger rise.

I would opt for a 15 year fixed loan and apply for it tomorrow.
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