Mortgage: Variable 7 vs Fixed 30.

[LongerPrimer]

DS just signed the papers with the seller. Asks which is better: A 7/1 Adjustable at 2.9%, no points or A 30 year fixed at 4,0% no points. The difference is payments is 240/mn, $20160 savings in favor to the Variable, assuming no rate increases. He assumes that he may not stay in this place and will rent it when he finds something else. Opinions?

[poker27]

It really depends on how long you will stay, and what the potential increase at the end of the 7 years is. I signed up for a 30year 2 years ago, and really wish I looked hard at a 7 year, since this will no be my/our forever home.

[LeeMKE]

Is this a trick question? The ARM is better.

1) the average span of home ownership is less than 7 years. If this is a first home, then they are extremely likely to move before the loan interest rate resets, and if they rent it out, rents will float to cover interest rate increases.
2) This is a GREAT opportunity to make some money tax free by pre-paying this mortgage. I've used ARMs by pre-paying the note, and the equity accumulation over 5 years is amazing. The lenders hate people who pre-pay these low interest rate mortgages because they are counting on having a substantial principal remaining on which to charge interest. You really blow out their profit by pre-paying the mortgage each month - - which should be entertainment enough to justify making the prepayments.

TRUE STORY: I once was the Real Estate Editor for a major newspaper, and wrote a column each week. I laid out a formula to use ARMs to get the benefit of the low interest rate, but protect yourself from payment increases by pre-paying the loan in the early years. I was doing the same on my own mortgage.

A few months later, the local branch contacted me, asking about why I was pre-paying my mortgage. "You can't skip a payment, you know." "Yes, I understand, I just want my house paid off sooner."
"Well, you know, this isn't doing you any good, don't you?" "Actually, it is pre-paying my mortgage, because I want to pay off my loan sooner."

And I carefully transcribed our conversation into my column for that week, and repeated the formula to prepay your ARM.

A few months later I get a call from the bank's regional office. They try to rough me up about the pre-payments. And once again I take careful notes and transcribe the whole thing into my column that week and again use the opportunity to talk again about the benefits of using an ARM to prepay your mortgage. (My column was carried by other papers up and down the west coast, so this was getting plenty of coverage.)

Another few months go by, and I get a call at the paper. My married name is different than my working name, so the caller confirms that I am indeed the borrower they have an ARM with who has been pre-paying our loan. "Well, we just wanted to assure you that we understand you want to pay off your loan early, and we are not standing in your way at all. By the way, it won't be necessary to mention our name in your column, right?"

"Certainly not. I wouldn't want my readers to think that only one bank takes such a critical view of pre-paying a mortgage. I suspect most banks would dish out the same treatment and my readers need to know that they have the right to prepay their mortgage." "Then you won't mention our name?" "Certainly not."

And then I wrote up the story for my column that next week, and left their name out.

[wilpat]

Interesting post. I wonder how many folks would buckle under with the verbal pressure not to pre-pay their loan!

[acegolfer]

If the borrower pays off the loan within 7 years (selling the house also results in paying off the loan), then 7/1 and fixed rate mortgage are the same product. Go with the lower rate 7/1 ARM.

If the borrower will not pay off in 7 years, then ARM is riskier for the borrower. Only he can answer whether he's willing to pay 1.1% higher rate in order to eliminate that risk.

[LongerPrimer]

Apparently most people have and currently still want the fixed rate mortgage.
I've came to the same conclusion as the kind replies. Go with the 7/1. Unbelieveable to see sub 3% mortgage of any type. He should take the variable and invest the rest. He should be able to get 6% ROI on that difference.: $21,000 at 0% ROR. $24,800 @ 6% ROR. $26,600 @8%. $28,500 @ 10%. So far he's been a pretty good investor.

thanks.

[grabiner]

Apparently most people have and currently still want the fixed rate mortgage.
I've came to the same conclusion as the kind replies. Go with the 7/1. Unbelieveable to see sub 3% mortgage of any type. He should take the variable and invest the rest. He should be able to get 6% ROI on that difference.

This is not a fair comparison, because a 6% return requires a fair amount of risk, while mortgage payments provide a risk-free return. The 6% return itself involves the same logic; if you expect to get 6%, you probably have a mixture of stocks and bonds. You could get a higher expected return by selling your bonds and buying more stock, but you presumably don't want to do this because of the risk.

And the bank is presumably indifferent between the two for similar reasons. If you take out a 7/1 ARM and don't pay it off within seven years, you take the risk that interest rates (and payments) will be much higher after the seven years. If you take out a fixed-rate mortgage, the bank runs the risk that you will still have the mortgage ten years from now and will be paying it down at below-market rates; the bank charges a higher rate to borrowers as compensation for this risk.

[acegolfer]

And the bank is presumably indifferent between the two for similar reasons. If you take out a 7/1 ARM and don't pay it off within seven years, you take the risk that interest rates (and payments) will be much higher after the seven years. If you take out a fixed-rate mortgage, the bank runs the risk that you will still have the mortgage ten years from now and will be paying it down at below-market rates; the bank charges a higher rate to borrowers as compensation for this risk.

+1.

In addition, if you decide to go with 7/1 ARM, read the fine prints such as adjustment caps (eg: +/- 2%) and lifetime caps (eg: +/- 6%). Not all loans have the same clause.

[Cosmo]

Is this a trick question? The ARM is better.

Not a trick question and the answer is not as straight forward as you seem to think it is. The OP did not make any indication if they were going to prepay or not.

grabiner wrote:
And the bank is presumably indifferent between the two for similar reasons. If you take out a 7/1 ARM and don't pay it off within seven years, you take the risk that interest rates (and payments) will be much higher after the seven years. If you take out a fixed-rate mortgage, the bank runs the risk that you will still have the mortgage ten years from now and will be paying it down at below-market rates; the bank charges a higher rate to borrowers as compensation for this risk.

+1 as well

Cosmo

[ralph124cf]

If you will take the 7/1 but pay as if you have the 4% fixed, I think that you will be in good shape. If you cannot pay at the 4% rate you cannot afford the house.

Ralph

[john94549]

FWIW, our daughter and son-in-law recently faced this same decision, and opted for the 2.9%, 7/1. I was also shocked that any financial institution would offer anything sub-3%, but perhaps it's not as unusual as I thought.

Ironically enough, the same financial institution is offering a six-year CD at 2.6% (2.35 plus a 25 basis point bonus for relationship customers). I guess they think they can still make money even on such a thin spread.

[inbox788]

It depends, as folks has said. FWIW, if you can't decide, you can split the difference with a Penfed 15/15 at 3.5%. Keep in mind fees. The 2.9% seems very good for the 7/1.

[LongerPrimer]

Just got back from a day trip to PDX and Ikea. DS called to say that mortgage broker is offering 20 year @3.65%.
He still hasn't grasp the concept.
Why would anyone want to pay off a 2,8% mortgage when you offset the loan with a 2.65% CD or Treasury or 4% dividend from a ultility?

[LeeMKE]

One more thought. Pre-paying a 2.9% mortgage makes you a MUCH HIGHER return than 2.9%.

Remember that every dollar pre-paid, reduces the principal upon which interest is charged on the next payment, thus compounding the risk free return. Not unusual to see 45% APR on amount of the pre-payment for a mortgage in the early years of a 30 year amortization. Can't beat this return, especially since it is risk free and tax free.

[acegolfer]

One more thought. Pre-paying a 2.9% mortgage makes you a MUCH HIGHER return than 2.9%.

Remember that every dollar pre-paid, reduces the principal upon which interest is charged on the next payment, thus compounding the risk free return. Not unusual to see 45% APR on amount of the pre-payment for a mortgage in the early years of a 30 year amortization. Can't beat this return, especially since it is risk free and tax free.

Sorry to be pedantic,

Using logic, doesn't investing in a 2.65% CD also makes you a MUCH HIGHER return than 2.65% because of compounding effect?

It seems that your definition of return doesn't involve annualized, even though you stated APR (=annual percentage rate).

[grabiner]

One more thought. Pre-paying a 2.9% mortgage makes you a MUCH HIGHER return than 2.9%.

Remember that every dollar pre-paid, reduces the principal upon which interest is charged on the next payment, thus compounding the risk free return. Not unusual to see 45% APR on amount of the pre-payment for a mortgage in the early years of a 30 year amortization. Can't beat this return, especially since it is risk free and tax free.

The return on a prepayment compounds at the loan rate. If you pay $10,000 extra on your 2.9% loan, your balance will be $10,290 lower next year, regardless of whether the loan is in the first or the last year. If you pre-pay in the first year, you may have 30 years of compounding, but that doesn't affect the APR.

The advantage of prepaying an ARM is that the interest rate may increase later. If you make a prepayment on a 7/1 ARM currently yielding 2.9%, you will earn 2.9% for the first seven years, and then you might earn 4.9% for the following 23 years if interest rates rise. The prepayment insulates you from the interest-rate risk on the amount which you no longer owe. (You could do the same thing by buying a seven-year bond yielding 2.9%, and then using the bond proceeds to pre-pay the mortgage when it is due to reset.)

[NorCalDad]

One more thought. Pre-paying a 2.9% mortgage makes you a MUCH HIGHER return than 2.9%.

Remember that every dollar pre-paid, reduces the principal upon which interest is charged on the next payment, thus compounding the risk free return. Not unusual to see 45% APR on amount of the pre-payment for a mortgage in the early years of a 30 year amortization. Can't beat this return, especially since it is risk free and tax free.

How are you calculating a 45% APR on prepaying a 2.9% ARM? I'd like to see your math.

I also think you are ignoring the opportunity cost of foregone investment. If you prepay $2,000 a month, as Grabiner points out, you earn 2.9% on that money and then earn whatever the rate is when the ARM resets. As far as risk-free rate of return, perhaps you can't do better than that. But if you are willing to assume risk and invest that $2,000 instead, you may come out farther ahead having invested rather than prepaid.

[acegolfer]

(You could do the same thing by buying a seven-year bond yielding 2.9%, and then using the bond proceeds to pre-pay the mortgage when it is due to reset.)

If I'm being too academic, my apologies.

To have exactly the same cash flow, he needs to buy a non-breakable 7-yr 2.9% CD not a 7-yr bond with YTM = 2.9%.

[denovo]

DS just signed the papers with the seller. Asks which is better: A 7/1 Adjustable at 2.9%, no points or A 30 year fixed at 4,0% no points. The difference is payments is 240/mn, $20160 savings in favor to the Variable, assuming no rate increases. He assumes that he may not stay in this place and will rent it when he finds something else. Opinions?

If they want to rent it (we can discuss whether or not that is a smart decision in another thread) he wants to keep the home long-term. Take the fixed-rate mortgage for sure!!! 30 yr 4 percent is a historical grand bargain, mortgages have been much higher for most of recent history. I wouldn't give that up.

[LeeMKE]

https://drive.google.com/file/d/0B0aSQQ ... sp=sharing

OK. It took me awhile to get this done, so I hope you'll take a look at it. ROI on the prepayment suggested by several of us is 51%. That is tax free, risk free. Drug dealers and wall street tycoons aren't making that kind of return (but bankers sure are).

[acegolfer]

How are you calculating a 45% APR on prepaying a 2.9% ARM? I'd like to see your math.

https://drive.google.com/file/d/0B0aSQQ ... sp=sharing

OK. It took me awhile to get this done, so I hope you'll take a look at it. ROI on the prepayment suggested by several of us is 51%. That is tax free, risk free. Drug dealers and wall street tycoons aren't making that kind of return (but bankers sure are).

That's not a math. That's a table without any explanation on how you derived the numbers.

Using extra principAL payment = $61.19, how do you get $1105.91 extra principAL reduction? I suggest you create a Google Sheet not a Google Document to show the formulas behind your numbers.

[LongerPrimer]

Still here and reading.

This is a starter home for a bachelor and a home to protect his future purchasing power, and for the next home which spouse will chose.

[john94549]

Still here and reading.

This is a starter home for a bachelor and a home to protect his future purchasing power, and for the next home which spouse will chose.

So, we're talking Instagram "Here's my house (see photo), will you marry me?"

[LeeMKE]

That's not a math. That's a table without any explanation on how you derived the numbers.

Using extra principAL payment = $61.19, how do you get $1105.91 extra principAL reduction? I suggest you create a Google Sheet not a Google Document to show the formulas behind your

Sorry you don't like the presentation. Please see the last column for formulas used and assumptions made.
If you want to check the numbers, use an amortization table as I did. Here's one I like:

https://drive.google.com/file/d/0B0aSQQ ... sp=sharing

[freddie]

I have a feeling that these formulas would get a much higher ROI is you only prepaid your mortgage by .01. You might want to think about what that means:)

My math is that if you didn't do any prepayments, your mortgage would be 83,550.19 at the end of year 7. So saved 5478. But what if you shoved that money in a 0% interest account. How much would you have? 5124. What type of return would you need to get those extra 350 odd dollars? About 3%:)


People don't really understand low interest rate mortgages. In the old days you saved a ton by prepaying because you paid a lot more in interest. Take a 100k at 8% (i.e. something like 2000). You would have paid 164k in interest over 30 years. With a 3%, you only paying 51k. With the low rates you are paying much more in principle early on so prepayments don't have the dramatic results in reducing the amount of interest paid.

How are you calculating a 45% APR on prepaying a 2.9% ARM? I'd like to see your math.

https://drive.google.com/file/d/0B0aSQQ ... sp=sharing

OK. It took me awhile to get this done, so I hope you'll take a look at it. ROI on the prepayment suggested by several of us is 51%. That is tax free, risk free. Drug dealers and wall street tycoons aren't making that kind of return (but bankers sure are).

That's not a math. That's a table without any explanation on how you derived the numbers.

Using extra principAL payment = $61.19, how do you get $1105.91 extra principAL reduction? I suggest you create a Google Sheet not a Google Document to show the formulas behind your numbers.

[LeeMKE]

Freddie, I agree with everything you said. Obviously, if the ROI falls from 50% to 25% with just a few dollars added, the most important prepayments are the first dollars of the earliest pre-payments.

And the premise is whether the ARM should be used, and if so, whether they should prepay the ARM or use the 30 year fixed. To that question, the answer is Yes, prepay the ARM.

Don't "invest the difference" and think you can come out ahead in 7 years. Getting folks to understand how important and profitable those early prepayments are, when the note is amortized over a long period, is tough.

I wish I could figure out how to post a table here, but below is the link to yet another google doc of an unfinished table of the cost of borrowing $1000 arrayed by interest rate and term.
$1000 borrowed for 30 years at 4% will cost you $719.00 in interest payments.
$1000 borrowed on a credit card at 18% for the usual term of 3 years will cost you $301.00 in interest payments.

My point is that paying attention to the term of the loan is very important. Actually, it is more important than the interest rate.
$1000 borrowed for 15 years at 3% will cost you $243.00 in interest payments.

https://drive.google.com/file/d/0B0aSQQ ... sp=sharing

[acegolfer]

That's not a math. That's a table without any explanation on how you derived the numbers.

Using extra principAL payment = $61.19, how do you get $1105.91 extra principAL reduction? I suggest you create a Google Sheet not a Google Document to show the formulas behind your

Sorry you don't like the presentation. Please see the last column for formulas used and assumptions made.
If you want to check the numbers, use an amortization table as I did. Here's one I like:

https://drive.google.com/file/d/0B0aSQQ ... sp=sharing

I used your amortization table, which has correct formulas. But I still didn't get $1105.91 extra principal reduction in year 1.

Using your file,
Without extra payment, end balance in month 12 = 97,877.17
With $61.19 extra pmt each month, end balance in month 12 = 97,133.05.
That's a $744.12 reduction in balance. How did you get $1105.91 reduction in year 1?

So using your method of c/(b*12), ROI extra pmt = 744.12 / (61.19 * 12) = 1.0134. Isn't that 1.34% return not 51%?

[freddie]

Again, prepayments are not very profitable on 2.9% loans. Look at your example where you put in almost 2 extra payments a year (in the 61 dollar case) and in 7 years you have saved a mere 350 dollars. Prepay an extra 133/month (almost 4 extra payments a year) and you save a grand total of 791. On average your going to do much better investing. Your odds of making 4% are very high with any type of 60/40 type portfolio. But if your willing to settle for 3% returns on your money, go ahead an paydown that mortgage.

Freddie, I agree with everything you said. Obviously, if the ROI falls from 50% to 25% with just a few dollars added, the most important prepayments are the first dollars of the earliest pre-payments.

And the premise is whether the ARM should be used, and if so, whether they should prepay the ARM or use the 30 year fixed. To that question, the answer is Yes, prepay the ARM.

Don't "invest the difference" and think you can come out ahead in 7 years. Getting folks to understand how important and profitable those early prepayments are, when the note is amortized over a long period, is tough.

I wish I could figure out how to post a table here, but below is the link to yet another google doc of an unfinished table of the cost of borrowing $1000 arrayed by interest rate and term.
$1000 borrowed for 30 years at 4% will cost you $719.00 in interest payments.
$1000 borrowed on a credit card at 18% for the usual term of 3 years will cost you $301.00 in interest payments.

My point is that paying attention to the term of the loan is very important. Actually, it is more important than the interest rate.
$1000 borrowed for 15 years at 3% will cost you $243.00 in interest payments.

https://drive.google.com/file/d/0B0aSQQ ... sp=sharing

[rleonardh]

You going to always have two school of thoughts here.

1) Never pay off home mortgagae (because they love paying the interest in the house more than the irs) and invest the extra payments
2) Invest 15% of total pay and make extra house payments (because we love sending irs a little bit compared to paying a lot for mortgage interest).

But considering you dont know if moving, why pay-off eairly?

[Auream]

Well, there's also the third school of thought, led by people like LeeMKE, who just fundamentally don't understand the math and think that pre-paying a 3% loan gives you a 51% APY return.

[LeeMKE]

Well, there's also the third school of thought, led by people like LeeMKE, who just fundamentally don't understand the math and think that pre-paying a 3% loan gives you a 51% APY return.

Keep drinking the kool-aid. The banking industry loves you.

[acegolfer]

Well, there's also the third school of thought, led by people like LeeMKE, who just fundamentally don't understand the math and think that pre-paying a 3% loan gives you a 51% APY return.

Keep drinking the kool-aid. The banking industry loves you.

LeeMKE,

I'm the one who said that quote. But I asked you to verify your math (51% APY return) earlier. Will you do it?

[LongerPrimer]

Thankyou and appreciate your efforts, LeeMKE. I happen to see your point and do understand it. My financial adviser has a saying about bankers, " I [banker] give you any rate and payment plan you want, I get to make the terms. "

I think LeeMKE is trying to say is, front loading (additional principal) a loan gets you more results than just the additional payments carried to term (nominal 30 years). Likewise front loading an investment will get you further ahead than DCA college or retirement programs. - Early investments/payments are more important than the last because of TVM.

[Auream]

Thankyou and appreciate your efforts, LeeMKE. I happen to see your point and do understand it. My financial adviser has a saying about bankers, " I [banker] give you any rate and payment plan you want, I get to make the terms. "

I think LeeMKE is trying to say is, front loading (additional principal) a loan gets you more results than just the additional payments carried to term (nominal 30 years). Likewise front loading an investment will get you further ahead than DCA college or retirement programs. - Early investments/payments are more important than the last because of TVM.

That doesn't make any sense. APY is APY, it includes the term "annual." Of course, if you let more years compound, you earn more. But that doesn't affect the annual yield. The annual "yield" of paying off a 3% loan is 3%. Period, no ifs and or buts.

[Dollar Bits]

If the borrower pays off the loan within 7 years (selling the house also results in paying off the loan), then 7/1 and fixed rate mortgage are the same product. Go with the lower rate 7/1 ARM.

If the borrower will not pay off in 7 years, then ARM is riskier for the borrower. Only he can answer whether he's willing to pay 1.1% higher rate in order to eliminate that risk.

Completely agree... I'd take the approach that if you KNOW with certainty that you will either relocate in less than seven years OR you will have the property paid off in less than seven years, then sure, go with the ARM. Elsewise, you might well be better off with the 30 year fixed. yes, you'll be paying more; a lot more; now, but if you are still in the house 20 years from now and haven't paid off the loan, you might well be happy with having the 30 year fixed. If at any point during the term of the loan rates on the 30 decline, you could always refinance.

[rleonardh]

Thankyou and appreciate your efforts, LeeMKE. I happen to see your point and do understand it. My financial adviser has a saying about bankers, " I [banker] give you any rate and payment plan you want, I get to make the terms. "

I think LeeMKE is trying to say is, front loading (additional principal) a loan gets you more results than just the additional payments carried to term (nominal 30 years). Likewise front loading an investment will get you further ahead than DCA college or retirement programs. - Early investments/payments are more important than the last because of TVM.

That doesn't make any sense. APY is APY, it includes the term "annual." Of course, if you let more years compound, you earn more. But that doesn't affect the annual yield. The annual "yield" of paying off a 3% loan is 3%. Period, no ifs and or buts.

APY is interst you pay, if you pay more now, you pay less later. Period, no ifs and or buts.

[LongerPrimer]

So, we're talking Instagram "Here's my house (see photo), will you marry me?"

Actually, it's, Tinder. DS needs to upgrade his car (96 Camry) but it runs well, interior is VG.

[Auream]

APY is interst you pay, if you pay more now, you pay less later. Period, no ifs and or buts.

Can you show me the math that indicates a higher than 3% annual yield from paying down a 3% loan?

[Ketawa]

One more thought. Pre-paying a 2.9% mortgage makes you a MUCH HIGHER return than 2.9%.

Remember that every dollar pre-paid, reduces the principal upon which interest is charged on the next payment, thus compounding the risk free return. Not unusual to see 45% APR on amount of the pre-payment for a mortgage in the early years of a 30 year amortization. Can't beat this return, especially since it is risk free and tax free.

You need to fix your terminology. There is absolutely not a 45% APR on prepayment. Now, maybe prepayments results in a 45% total return after 30 years. That is a mostly meaningless number. Today, I could purchase a 20-year zero coupon Treasury for about $513 dollars. When it matures, I would receive $1000. Look at that, I could get a 95% return in only 20 years, and I'm not a drug dealer, Wall Street tycoon, or banker!

I suggest you read grabiner's posts more carefully.

[LongerPrimer]

Any how, Supposedly DS is going to discover the terms of the ARM 7/1 sometime today.

[LongerPrimer]

New development. Local bank is offering ARM 5 year, 2% cap after 5th year. Await the details.

[LongerPrimer]

Flash news. You hear it here, first.
Unbelieveable.
ARM 7/1. 5/2/5, @2.625%, no points. Conforming. Verbal. Need to see it in writing.

[Auream]

Flash news. You hear it here, first.
Unbelieveable.
ARM 7/1. 5/2/5, @2.625%, no points. Conforming. Verbal. Need to see it in writing.

Hard to believe. What's the bank or broker?

[inbox788]

Flash news. You hear it here, first.
Unbelieveable.
ARM 7/1. 5/2/5, @2.625%, no points. Conforming. Verbal. Need to see it in writing.

Hard to believe. What's the bank or broker?

Yeah, hard for me to believe too, since it's been a while since I've seen rates in this range, but it's close. Maybe they misquoted the 5/1.

https://www.aimloan.com/rates

http://www.bankrate.com/funnel/mortgage ... &prods=9,6

[LongerPrimer]

Don't want to jinx it.
He found it through a very popular portal which gave him a local broker.
We need to see the terms in writing.

[pteam]

Well, there's also the third school of thought, led by people like LeeMKE, who just fundamentally don't understand the math and think that pre-paying a 3% loan gives you a 51% APY return.

Haha that was too funny!

[LongerPrimer]

I don't particularly like ad hominems especially in a thread that I started.
I can understand where LeeMke numbers are coming from and going towards. I happen to believe in the concept in prepaying, acceleration, when the numbers fit. Mentally I use a what-if situation where one makes a cash purchase and invests-the-rest vs a financed purchase. Currently, the advantage of mortgage acceleration for DS is not advantageous based on the numbers I got last night.

2.625% ARM 7/1, 5/2/5, 0 pts. 0 fees, confirmed in documents that broker sent to DS-I will see docs later, hopefully today's email. Lender's written confirmation to be on Tuesday. Local broker found through Zillow, this past weekend. Broker does not advertise on weekdays, only weekends because he has all the volume he can handle (who would think this?). DS did not bookmark this ad for Monday's review, but had the memory enough to make a good guess for a google search. Savings on this ARM over a 4%-30 year, is big enough to fund taxes. It is doubtful that DS will accelerate loan since he is making much more in investing.

[LongerPrimer]

Got a copy:
2.625% Rate. 2.778% APR. 7/1 ARM, 2/2/5 [2% max on first adjustment, 2% max on subsequent periods, 5% max lifetime (7.625% Rate).]