Fixed vs ARM mortgage

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sunny_in_socal
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Joined: Mon Oct 26, 2020 7:01 pm

Fixed vs ARM mortgage

Post by sunny_in_socal »

I feel like I know what the answer to this question will be, put I've learned so much here I thought maybe I will learn something new now.

I am likely closing on a mortgage for 976,000 this week. (20% down on 1.22MM) I have one lender offering 30-year-fixed at 2.85% and a second lender offering 7-year-ARM at 2.65% plus 4k rebate of closing costs. To me the 30-year at a historically low rate seems like a no brainer, but I also know that most mortgages are held for less than 7 years. By my calculation, if I did sell at 7 years, the ARM would have saved me about 18,000 including the 4k rebate.

For what it's worth:
Household income - $440k annually
Cash and taxable savings - $350k
Retirement savings - $500k
Debt - zero

The mortgage/income ratio is 2.22, which is higher than I would like but within expectations for southern California in a desirable neighborhood.
I'm currently renting and saving 36% of gross income between retirement and taxable accounts, and expect that to drop to no lower than 30% once mortgage payments start.

I guess the real question is does purchasing the house even make sense if I might move in 7 years? I'm not planning on moving but who knows, I'm not anchored here for any reason beyond my job and loving the city..

Thanks for any thoughts!
Tingting1013
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Re: Fixed vs ARM mortgage

Post by Tingting1013 »

Buying is almost certainly cheaper than renting for you, so that’s one reason to buy even if you think you’ll move within 7 years.
strafe
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Re: Fixed vs ARM mortgage

Post by strafe »

I would take the 30 year fixed. The interest rate savings on the ARM is too small relative to the option value of the 30yr fixed.
megabad
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Re: Fixed vs ARM mortgage

Post by megabad »

I think you hit the nail on the head. ARMs make sense if ownership cycle is short, but short ownership cycles on housing are extremely high risk.

I think the focus should be on whether you want to buy a house at all. If so, I would likely get a fixed rate mortgage and intend on staying a long time. This is mostly a lifestyle question.
dandinsac
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Re: Fixed vs ARM mortgage

Post by dandinsac »

You could also run the numbers to put an additional $200,000 down to get the loan balance to be conforming (e.g., $765,600 or less for Orange or LA County.) You may be able to get even a lower rate. This wouldn’t be a good option if you are hit with capital gains taxes by selling stock in a taxable account. But if you otherwise have cash in low rate accounts, it may be worth it.
presto987
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Re: Fixed vs ARM mortgage

Post by presto987 »

I would definitely go with the ARM. The $18k that you cited is a very strong datapoint in favor of that. Plus, as dandinsac points out, you will be able to get better 30-year rates once you get below the superconforming limit. Currently the limit is $765,600, though it may go up a bit in 2021. So you could take the ARM now, and if you get under the limit in the near future, you can try to refi into a more competitive 30-year rate. For example, Interactive Mortgage is currently advertising a 2.5% 30-year with all closing costs covered if you are below the superconforming limit and meet other criteria (e.g. <60% LTV). Even if you don't get under the limit, you can refi and use the $4k rebate you made now to buy down your rate and come out with an even better 30-year rate. I actually think that is unnecessary, but my point is that the rebate is valuable, and you have a lot of options when it comes to refinancing in the future. There is no reason to think that the mortgage you take now is the one you will be stuck with forever.

Also, think of it this way. Suppose I handed you $4k and gave you a 7/1 ARM at 2.625%. Would you then be willing to pay me $4k for the privilege of increasing your interest rate by 0.25% and extending the fixed period from 7 years to 30 years? This only makes sense if you truly expect to be in the house for a long time and are averse to refinancing (or expect interest rates to shoot up).

Out of curiosity, which lenders are you working with? Your ARM deal is a good one.

My experience may be helpful. I was in your position 4 years ago. Bought a house in SoCal for a very similar price and 20% down. My financial situation was very similar to yours, though my cash/taxable investments were a bit higher. I got a 7/1 ARM at 2.5% with $6k of lender credit. (Admittedly, at that time, 30-year fixed rates were higher than they are now).

We are now looking to move within the next year, so the 7-year term wound up being more than enough. When we bought the house, we did not necessarily expect to move after 5 years, but we knew it was a possibility given our situation. It's important to think about what stage of life you're at. If you have a growing family, you might outgrow the house after several years and want to move. There may be other considerations like schools. If your income is on an upward trajectory, maybe you'll want to upgrade to a nicer/bigger home. Etc.

Even though we will be moving within 5 years, I am certainly glad we bought this place rather than continuing to rent. With interest rates as low as they are (plus the mortgage tax deduction if you itemize), the math is more favorable to own than rent even if you don't get much house price appreciation. Plus if you plan to own a house in the future, it's a good idea to buy now as a hedge against potentially rising house prices.
Adfmacro
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Re: Fixed vs ARM mortgage

Post by Adfmacro »

In 7 years the rates could be much higher and if there are less buyers then to sell would require a discount on price. Also in 7 years the sales commission would be around 90,000. You might like to sell in 7 years but you don’t want to be pressured to sell.

I hope you are pretty young since dropping to less than 1.5 times salary in combined savings is a pretty low percentage unless you are young. In addition to the 7 years for the ARM what are the other terms? How high and how often can they change thereafter and is there a lifetime cap?

Ownership for less than 5 years and you are better off renting. Ownership for more than 10 years in most cases owning makes the most sense. 7 years and I think it is a toss up. I think you should plan to stay longer than 7 years and go with fixed. If you really think you will want to move in 7 years, life might be a lot easier by just renting. Owning for just 7 years may not be worth the risk.
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unclescrooge
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Re: Fixed vs ARM mortgage

Post by unclescrooge »

I would take the 30 year is there was no cost to it.

Who is the lender for the ARM?
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BrandonBogle
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Re: Fixed vs ARM mortgage

Post by BrandonBogle »

presto987 wrote: Mon Oct 26, 2020 11:04 pm I would definitely go with the ARM. The $18k that you cited is a very strong datapoint in favor of that. Plus, as dandinsac points out, you will be able to get better 30-year rates once you get below the superconforming limit. Currently the limit is $765,600, though it may go up a bit in 2021. So you could take the ARM now, and if you get under the limit in the near future, you can try to refi into a more competitive 30-year rate.
This. Don’t focus on what you will do in 7 years, but what you will do in the next two. You very well may refinance in the next two years and that is a rather large savings.

Out of curiosity, what is the cost for the 30-year? And how much would points be if you bought it down that quarter percent? Not that I’m advocating getting the 30-year, but then you can better compare apples-to-apples.
Topic Author
sunny_in_socal
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Re: Fixed vs ARM mortgage

Post by sunny_in_socal »

These are all great thoughts, thanks everyone.

The ARM is with First Republic. The fixed has $1700 in lender and processing fees, but no "origination" fees.

I'm 42. Due to a variety of good/bad life choices I didn't start saving until 35 so still have a lot of need to grow my savings, but even after removing the down payment from my portfolio, firecalc still has me on track for FI by my target of 55.
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unclescrooge
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Re: Fixed vs ARM mortgage

Post by unclescrooge »

sunny_in_socal wrote: Tue Oct 27, 2020 8:17 am These are all great thoughts, thanks everyone.

The ARM is with First Republic. The fixed has $1700 in lender and processing fees, but no "origination" fees.

I'm 42. Due to a variety of good/bad life choices I didn't start saving until 35 so still have a lot of need to grow my savings, but even after removing the down payment from my portfolio, firecalc still has me on track for FI by my target of 55.
I spoke to first republic recently.
They are super competitive in the jumbo space and aggressively marketing in Los Angeles. But they wanted us to move our entire banking relationship to them.
vinhodoporto
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Re: Fixed vs ARM mortgage

Post by vinhodoporto »

I look these decisions this way: with the fixed you're buying an option that protects you in the case that you keep the property more than 7 years and that rates go up.

One question I always ask in this situation - what is the worst case scenario with the ARM vs. fixed rate?
- How much income would you need to pay the fixed rate if you lost your job and had to find something else? How easy would it be for you to get that income in the midst of an an economic downturn?
- How much income would you need to pay the ARM if you lost your job and had to find something else AND the ARM reset to the maximum rate? How easy would it be for you to get that income in the midst of an an economic downturn?

I've done an ARM in the past when I was comfortable with the answers to the above questions, but would be hesitant to do one now because:

1) The spread between the fixed rate and ARM is not that high, which means the option I mentioned above is fairly cheap

2) Given that we have historically low rates, there's not much room for them to go down further, so BEST CASE rates are about where they are now when you need to refi or sell

3) There's a lot of potential risk in the economy right now given COVID, political questions, high levels of govt spending and debt, high stock market valuations etc. This may be a problem if you need to sell in the future when the ARM start to float or if you lose your well paying job

4) House prices in many places area at highs. If rates increase and/or the economy goes backwards, that could negatively impact house prices. This is a problem if you need to refi or sell in the future when the ARM start to float or if you lose your well paying job
WS1
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Re: Fixed vs ARM mortgage

Post by WS1 »

vinhodoporto wrote: Tue Oct 27, 2020 9:40 am I look these decisions this way: with the fixed you're buying an option that protects you in the case that you keep the property more than 7 years and that rates go up.

One question I always ask in this situation - what is the worst case scenario with the ARM vs. fixed rate?
- How much income would you need to pay the fixed rate if you lost your job and had to find something else? How easy would it be for you to get that income in the midst of an an economic downturn?
- How much income would you need to pay the ARM if you lost your job and had to find something else AND the ARM reset to the maximum rate? How easy would it be for you to get that income in the midst of an an economic downturn?

I've done an ARM in the past when I was comfortable with the answers to the above questions, but would be hesitant to do one now because:

1) The spread between the fixed rate and ARM is not that high, which means the option I mentioned above is fairly cheap

2) Given that we have historically low rates, there's not much room for them to go down further, so BEST CASE rates are about where they are now when you need to refi or sell

3) There's a lot of potential risk in the economy right now given COVID, political questions, high levels of govt spending and debt, high stock market valuations etc. This may be a problem if you need to sell in the future when the ARM start to float or if you lose your well paying job

4) House prices in many places area at highs. If rates increase and/or the economy goes backwards, that could negatively impact house prices. This is a problem if you need to refi or sell in the future when the ARM start to float or if you lose your well paying job
If the world was in WORSE shape in the future why would interest rates be higher? If this thread was 18 months old, we’d basically be living the “worst case scenario” predicted in the thread.
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