Financial Samurai

“If you plan to live in your house for 10 years, take out a 10 year fixed rate as the most conservative loan duration.” I think the problem with this is many people will not be able to make the payments that go along with a 10 year fixed rate mortgage.

I think many people (a much greater percentage of people in general than your readers) take out a 30 year fixed as 1) they need the 30 year amortization to be able to make the monthly payment and 2) they do not want to be surprised with the higher payments that may come if they take an adjustable rate 30 year loan.

Many people that would not qualify for 30 year fixed rate mortgages, were given adjustable rate mortgages in the early 2000s, so that they qualified for the mortgage. Then the rates went up on them and they could not make the monthly payments and lost there houses. I think not wanting this to happen to them, is a reason people have switched from adjustable to 30 year fixed rate mortgages.

I love question #6, “6) How much more are they going to make off you.”

BTW in #3 “Quick” s/b “Quiz”

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Financial Samurai Reply:
May 2nd, 2012 at 8:05 am

To clarify, I mean a 10 year fixed ARM (30 year amortizing). That’s what I mean for a 5/1 ARM (30 year amortizing) as well.

Rates didn’t go up David. They went down, down down, so those who took ARMs to qualify are now paying a LOWER payment than when they first started.

It was the donkey who took a NEGATIVE AMORTIZATION LOAN and didn’t understand, where the total payment likely went up.

thx

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David M Reply:
May 2nd, 2012 at 4:23 pm

You are correct, I was thinking about the contracts written so that the rate was aftificially low at the beginning and then went up. Likely those lousy conditions were in the NEGATIVE AMORTIZATION LOANS.

BTW – 10 year bond rates are down significantly today – maybe I will refinance again and if the rate is lower, I will go with a 5 or 7 year ARM from my 10 year fixed – I will accelerate the payments.

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Financial Samurai Reply:
May 3rd, 2012 at 3:28 pm

Hope you get a good rate!

Kan Reply:
July 18th, 2012 at 6:17 am

David,
your point about people’s rates going up after their teaser rate when they took out ARM because they didn’t qualify 30 year fixed, is a moot point. Those people shouldn’t have bought a house that they couldn’t afford in the first place. The point of this article is comparing 30 year fixed to ARM to a person who would qualify for both. And in those cases, ARM would come out ahead instead of 30 year fixed. You can’t compare people who wouldn’t qualify for a 30 year fixed in the first place and say that they got screwed with their ARM rate. If those people would’ve somehow qualified for 30 year fixed, they would be struggling to make a payment from the first day.

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I think that so many people take out a 30 year fixed mortgage for emotional reasons and as David M mentioned, affordability.

I had planned on taking out a 7/1 ARM on the condo I planned on buying earlier this year because I did some calculations and figured that I might not stay there more than 7 years. The math certainly showed that the 5/1 ARM was the smarter mathematical choice, but I felt that it was more likely for me to stay there for 5-8 years than 3-6 years and so the 7/1 ARM felt “safer” to me emotionally than the 5/1 ARM.

I will probably end up going with a 5/1 ARM on the next place that I try to buy, especially with the math of how much principle I could pay down in those 5 years (all of it) if I don’t move.

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Financial Samurai Reply:
May 3rd, 2012 at 3:29 pm

You just have to do the math. I would go with a 5/1 ARM, and maybe a 7/1 ARM if the spread isn’t more than 0.25-0.375% higher.

But, I would also reconsider purchasing if you plan to live or own there for just 6-7 years.

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I actually agree with you in principle, but the section “If rates rocket higher, you will be celebrating” is a little unfair. Until the unprecedented government intervention in mortgages (and extra-governmental, like from BenGenie), there was a larger spread between inflation expectations and mortgages. So, not only have inflation expectations dropped but returns baked into mortgages have dropped as well – win-win!

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Financial Samurai Reply:
May 3rd, 2012 at 3:29 pm

Is it unfair to thank our lord, BenGenie?

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Meh. In Canada, we don’t have the opportunity to fix rates for such a long period of time, so usually we compare between 5 year variable or 5 year fixed. I say meh because given a 30 year period of time, a lot can happen. There’s no guarantee that the value of your home will keep up with inflation to the degree that you expect.

The funny thing is, I also think rates are going to stay low even in the face of inflation. The fed is not likely to subject treasury rates to market forces, for how would the USG finance its spending? So it’s entirely possible to get negative real returns, as we’ve been seeing.

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Invest It Wisely Reply:
May 2nd, 2012 at 8:06 am

P.S. love these posts that challenge the status quo. :)

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Financial Samurai Reply:
May 2nd, 2012 at 12:13 pm

I really hope folks learn something from this post, and other posts on real estate. There are too many zombies out there who don’t bother to understand and think for themselves.

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Nice chart. You make a good point about locking in an ARM for a shorter duration, 2.6% is definitely hard to beat.

It looks like the investment play of a lifetime was buying 30 year treasuries paying 15% interest back in 1982… at least from a fixed investment perspective!

-Mike

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Financial Samurai Reply:
May 2nd, 2012 at 8:17 am

Ah yes, how nice that would be!!! Can you imagine? Not only would you get a 15% return on your initial principal, the principal value of the bond would have kept going up and up and up.

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JT Reply:
May 2nd, 2012 at 11:43 am

Fixed-income beat equities from 1981-2011. First 30 year period that had ever happened since the 1800s. If only you could go back in time…

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Perhaps I am not understanding, but I want to lock in a ~4-5% rate for 30 years. That’s pretty close to the yearly “reported” rate of inflation. Overtime you will be paying back the mortgage with inflated dollars, or with your tenant’s dollars.

Sure I am paying more interest overtime, however, when you factor in inflation, wouldn’t you agree that fixing in a long-term rate over 30 years is better? IMO, when you locking a 30 year mortgage with a cash flowing rental, I don’t really see the need to pay down or pay off the mortgage any sooner. If I can get a solid 15-18% return at the cost of borrowing at 5%, would it make sense to keep those ratios in place?

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Financial Samurai Reply:
May 2nd, 2012 at 12:15 pm

Because everything is relative. I would lock at a 4-5% rate over 30 years b/c I can lock at a 2.625% rate over 5 years with an interest rate cap, and a belief that interest rates will continue to be benign as it has been for the past 30 years.

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I don’t know man. I like the 30 years fixed rate loan. So many people got in trouble for those ARM loans. You’re the exception because you know more about finance and mortgages, but I wouldn’t recommend ARM for the normal paycheck to paycheck workers.
Anyway, Mrs. RB40 decreed that we are done moving so a 30 years loan works for us. :)

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Financial Samurai Reply:
May 2nd, 2012 at 9:14 am

Again, nobody got in trouble because of an ARM loan since when the lock expired the rates went DOWN.

People who got in trouble were b/c they risked too much and didn’t have enough savings, alternative incomes, buffers etc that wiped them out completely. Finally, pls differentiate between NEG AM loans and ARM loans.

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ron Reply:
October 23rd, 2012 at 5:57 pm

It doesn’t take a rocket scientist to figure out that 23 years of interest at 7.5% will wipe out the gains you make paying 2.5% for five years and 4.5% for two years then finally 7.5% for the rest. I like the other guy’s post about how locked rates protect you from inflation. Pretty soon my 3.25% fixed rate mortgage payment is going to feel like chump change. Meanwhile all the people that saved all that money on a 5/1 ARM are refinancing and getting rates that are higher. Good luck with that. If you plan properly then you would be fine but it’s not the no-brainer that you are suggesting.

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Financial Samurai Reply:
October 23rd, 2012 at 7:33 pm

Why would you want to pay 7.5% when you can pay 2.25% now for a 5/1 ARM for the first five years guaranteed, and below 3% for the duration of your loan? Feel free to pay more to the bank if you want. And feel free to take 30 years to pay off your loan to pay the maximum interest. Banks need your money!

In my case, I am planning to keep it and rent it when I move out. I plan to have it paid off in far less than 30 years though.

I think the biggest argument for the 30 year fixed is the peace of mind. Sure there are some costs to that, but I don’t look at my interest as simply interest expense. I pay a lower mortgage payment now than my rent was at my old apartment. I just look at it as rent with equity built in.

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Financial Samurai Reply:
May 2nd, 2012 at 10:19 am

I guess I see things differently. I would have negative peace of mind w/ a 30yr fixed knowing that I am paying more every month that I could have for years to come.

But, both are good choices. So long as one is taking advantage and refinancing now.

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So the previous 30 years will be like the next 30? I don’t think so. Past performance doesn’t equal future results. I’m assuming you think we are Japan then?

The average rate of inflation during the past 30 years has been 3.8%. So you are saying rates like I have for my new 30 year mortgage at 3.875% which pretty much match the inflation rate is a bad deal (not including mortgage deduction). It’s free money if adjusted for inflation. When you stated on my last comment, there was no inflation – 2.8% for the trailing year is no inflation?

I’m not completely against say a 7 year ARM, if you know for a fact you will leave in that timeframe. Being forced to refi at that time is a bad idea, if you will stay.

Many state they will not stay after 7 years, and then wind up not moving or can’t move for various reasons. A 30 year allows you to sell a property on your terms, not because of market rates of mortgages or property value.

With rates so low, mortgage payments are becoming mostly principal.

I figured out for a $300k 30year fixed at 3.875% compared to 2.849% (what I could find online at bankrate.com) for a 7 year ARM was $170.20 difference per month. not large, but not small either.

Or $2042.4 per year or $14,296.80 for the 7 year term.

You could quickly lose out in being forced to sell at that time, or to refi, once the 7 year term is over.

Also, I know you are for mortgage prepayment, while I’m not. So it’s six of one, half a dozen of the other.

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Financial Samurai Reply:
May 2nd, 2012 at 11:15 am

Your example of Japan SUPPORTS my argument for borrowing on the short end Larry. Rates have done nothing but go down in Japan.

I really hope you dont take 30 years to pay off your mortgage. How old will you be then?

30yr fixed is not a BAD choice. It is the suboptimal choice for most people between too good choices for refinancing now.

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Investor Junkie Reply:
May 2nd, 2012 at 11:50 am

Let me ask you this: You think the 10 year will go to 1% in say the next 10 years? What about 1.5%? Since you are correct the 10 year affects mortgage rates, but as you know it’s not completely in direct proportion to mortgage rates. ie a 500 basis point drop in the 10 year, does not mean mortgages will drop 500 basis points.

You would agree, right now there is much more upside risk than downside to mortgage rates. A 7 year (or more common 5 year) ARM only locks you in for so long. Then you have to deal with variables in rates, that are probably higher. Or an ARM cap I’ve seen some as high as 3% annually, though most are around 2%.

This also forgets the tax issue. I donno about you, but where I live the biggest risk is property tax increases. It’s possible in the situation you mention getting hit with a double wammy in rate increase, and also dealing with the contant tax increases from your municipality. At least the mortgage rate is a kown fixed. For me our home our taxes is 1/3 of our monthly fee currently, I suspect in 10 years it will be closer to 1/2 of our monthly payment. The county I live in, Nassau, is bankrupt.

“I really hope you dont take 30 years to pay off your mortgage. How old will you be then?” 70 and who says you must have all debt payed off when I am “retired”? Why does it matter if you aren’t working. If you have the cash flow, it should not matter. We may or may not pay it off before then, but it’s our decision and not being forced to.

My wife and I talked about it for our primary residence we plan on staying there at least for the next 10 years. In our case that is pretty much a known because of our children, and her career (I can live anywhere with my career, and would prefer to live in a low taxed state/country but is another discussion). We don’t plan on moving either to another town on Long Island, or to another state at least during that time.

Though for retirement we do plan on NOT living in New York, but who says we will sell our primary residence? Living in more than one state is the optimal option to minimize state taxes for a high taxed state like NY or CA.

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Financial Samurai Reply:
May 2nd, 2012 at 12:11 pm

Let’s put it this way. By going a 7 yr, you are saving 1% a year for 7 years going this route over a 30 year.

You would need to pay 2% more for 7 years to THEN start losing money, and that is IF interest rates do move up by that much, which I do not believe will be the case.

So in essence, your 7 year has bought you 14 years of time in a RISING interest rate environment before you start to have a suboptimal return.

I’m impressed you want to still work at 70 years old. I don’t.

Investor Junkie Reply:
May 2nd, 2012 at 12:22 pm

If you enjoy what you do it’s not “work”. What I care about is financial freedom and that will occur long before I’m 70. Setting goals by “work” IMHO is what causes people to still live and gives a purpose. I agree I won’t be as active as I am now, but I certainly will not be retired. retirement = death.

I agree with you in a completely controlled environment where someone says they will move and do actually move from one home to another while selling their first home. I also agree that ARMs are completely different from Alt-A or negative amortization loans where the payments were capped, but not the interest rate. A payment cap is one thing, an interest rate cap is something different entirely.

In terms of the yield curve, it should be mentioned that the biggest “subsidy” on the curve is in the long-dated securities – those with 20+ years to maturity. The FED is most active on the long-end, essentially subsidizing anyone who borrows for longer periods more so than people who borrow on the short-end.

It’s all a matter of where you want to risk your income and capital. If people follow the typical rule and spend 25-30% of their monthly cash flow on a home, a fixed rate is a necessity. However, if people spend 15% on a home, there’s more room to “gamble” on an ARM.

If you’re wealthy with consistent income sources, an ARM is obviously the better option. If you’re not wealthy, or have some income risk, then a 30-year fixed is a better alternative. It also comes down to your own income growth. Someone who works for an hourly wage is unlikely to see their wages increase at a rate equal to that of inflation – especially in periods where inflation is higher than average. A business owner or salesperson, people essentially paid on commission and who experience income growth consistent with the published inflation rate, would have more leg room to say that inflation has zero real effect on their personal capital structure and could therefore tolerate the rate risk with an ARM.

Let’s see where you really stand on ARMs vs. fixed rates: are your rental properties financed with fixed-rate financing, or variable? (Assuming that fixed-rate financing on your investment property is actually an option.)

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Financial Samurai Reply:
May 2nd, 2012 at 11:45 am

My main rental property was a 30year fixed rate when I first bought way back. Then I learned and it is a 5/1 ARM at 3.125% after a refi in 2011. Rental mortgage rates are generally 0.25% higher than primary residence. A 30yr fixed would have been around 4.25% at the time. The loan is so small now, that I don’t want to bother ever refinancing again.

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JT Reply:
May 3rd, 2012 at 8:18 am

Fair enough.

I regard the decision between variable and fixed rates to be one of the most personal decisions in personal finance. It’s one thing to go long/short Treasury futures, and an entirely different matter to embed the risk into a home in which you live. The only decision that really bugs me with mortgages is the number of people willing to take a 15-year over a 30-year. From my perspective that’s 10x more egregious than taking a fixed-rate over a variable rate.

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Financial Samurai Reply:
May 3rd, 2012 at 8:31 am

Let us know if your feelings change when you get a house or a mortgage. thx

David M Reply:
May 3rd, 2012 at 9:55 am

JT why do you say that?

I took a 15 year when I purchased my house as I could easily make the payments and the rate was about 1/2 of a point lower.

After having this 15 year mortgage for 2 years – I refinanced into a 10 year mortgage. The rate on my 10 year mortgage was 1.25% lower than my 15 year mortgage – rates went down during the time period and maybe the 10 year is 1/3 point less than a 15 year.)

Since I can easily pay the 10 year loan – why shouldn’t I do this?

Financial Samurai Reply:
May 3rd, 2012 at 9:58 am

I’m wondering the same thing. Before you get into a heated battle, please get to know JT more eg background, homeownership experience, hobbies, etc. thx.

JT Reply:
May 3rd, 2012 at 11:54 am

It comes down to bankruptcy law and shelters, tax deductions for interest in excess of the standard deduction against W-2 income, and the long-run cost of borrowing, which is incredibly low right now.

Allow me to make my own appeal to authority: (at least I won’t poison the well to win an argument)

Ben Bernanke (an economics student!) and someone who earns a substantial income could afford to pay off his home. He hasn’t and actually he just refinanced into another new 30-year mortgage. Given that he is a very high-income individual (easily a 1%er due to his textbook, investment, and Fed income) and someone who understands economics, clearly my view that a 30-year mortgage is better than a 15-year mortgage is substantiated by the fact that Bernanke himself is using his home as a source of leverage, borrowing for 30 years at currently record low interest rates.

http://online.wsj.com/article/SB10001424052970204336104577094700478530784.html

Not surprisingly, he hasn’t made any real prepayments toward his mortgage, instead keeping his LTV at right around 80% – the minimum possible. As he is also 53 years old, it is likely that he will retire well before his 30-year mortgage is paid off. Why would he be borrowing on the long-end of the curve if all rational people are instead borrowing on the short-end?

As an econ graduate and central banker, he should know better than that, shouldn’t he? As the chairman of the single institution most responsible for interest rates on US dollar denominated credit, wouldn’t he be privy to better information than you or I?

David M Reply:
May 3rd, 2012 at 12:10 pm

JT,

Thanks for the reply!

I don’t understand the reasoning behind most of reasons regarding, “bankruptcy law and shelters, tax deductions for interest in excess of the standard deduction against W-2 income”. But not knowing is fine with me.

Regarding the low cost of capital – I agree it is really low. However, since I’m not confident that I will make more money with my money even with the low cost of capital – I’m happy to pay off my mortgage over 10 years.

Again, thanks for your reply!

Sam, no worries about getting into an argument with JT, I may not always agree with him but he always makes well thought out comments that I like to read and respect!

JT Reply:
May 3rd, 2012 at 1:37 pm

David,

Depending on your state, you probably have BK/litigation protection for a very small part of your house and a very LARGE part of your 401k/IRA, if not all of it. Given that you can borrow at 3.X%, I feel it makes sense to keep the debt at least until you have maxed out annual limits on any BK-protected accounts. So when people borrow for 15 years in lieu of borrowing for 30 years to use excess cash flow to invested in a BK protected account, yeah – it irks me.

Any interest you pay on a mortgage above the standard deduction on your taxes is a net reduction to your tax burden at your highest income bracket that you fall in. So if you get taxed at a 35% rate, your 4% mortgage rate is more like 2.6% (assuming it’s all deductible.) The mortgage interest tax deduction is essentially a synthetic Roth for rich people. Borrow money to reduce your tax burden now at your W-2 tax rate, and invest it in a traditional 401k/IRA to be taxed at your income tax when you’re retired. Or, alternatively, invest it in a taxable account and pay only 15% on the capital gains.

BK and tax advantages aside, it doesn’t include the insurance against the risk of falling real estate prices. Imagine walking away from a home you owned only 20% of in a down market where RE falls 50% in value with $3 million in a 401k/IRA that is sheltered entirely from litigation/bankruptcy. You made the bank a fool – they eat the losses (as they legally should) and you’re untouchable. Hell, you may walk out the door tomorrow and be disabled for life with medical bills to the moon, but that 401k/IRA balance is still yours. (Again, depends on the bankruptcy laws in your state, and I am not a lawyer.)

These reasons (along with my belief that equities will outpace the current cost of 30-year financing) are the reasons why I wouldn’t ever consider having equity in my home. Sam likes to make it out to be the case that it’s my ignorance of never having a mortgage payment, but to me, the math checks out.

It’s a creative financing maneuver, but a lot of people do it because of the tax savings, BK protection, etc. Whole life insurance doesn’t appear to make a whole lot of sense, either, but just ask any divorcee or a Dr. hit with a medical malpractice suit what he/she thinks of WL insurance. ;)

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Financial Samurai Reply:
May 3rd, 2012 at 3:45 pm

Hmmm…. if we are going down the road of discussing bankruptcy, then perhaps all hope is lost? What percentage of Americans go bankrupt? Is this not a very MINUTE point of discussion since the numbers are small?

Bankruptcy protection for the 401K/IRA is a good argument for why one should max them out. But we’re Financial Samurai here. That is a given!

The discussion is on ARM vs. 30-year fixed. If equities outpace 30-year financing, equities will surely outpace a 5/1 ARM’s rate.

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David M Reply:
May 3rd, 2012 at 4:13 pm

Sam,

Thanks for replying BK means bankruptcy – seriously I did not know that. I was just about to Google it and then I saw “bankrupt” and I figured it out.

JT – again thank you very much for your long and well thought out response.

1) I realize what the law says regarding mortgages – however, the law and what I would do are not always the same thing. To me the value of my house could go down 60% and I would want to make the payments. My house is a place to live and what I can sell it for when I decide to leave it is irrelevant.

2) I an now and for the last 20 years have maxed out my 401K – so no worries there.

3) Equities, I’m pretty well invested with my 401K, IRA’s and I also have a good amount invested outside of retirement accounts and put $ in each month.

Thus, even if it not the BEST choice – I am very happy to be rapidly paying off my mortgage and will be very happy to have it paid off in less than 10 more years – maybe even less than 5 years.

Again, thanks for you well thought out response!

JT Reply:
May 3rd, 2012 at 8:30 pm

Total loss is rare, but total loss is several magnitudes larger than a 10% loss. A 10% loss is not 10x better than a 100% loss. The loss of one additional dollar is more important at the margin than the loss of the dollar before. As an economics graduate, you should understand that. As a poker player, you should understand that having a “chip and a chair” (something) is better than having zero.

I made the point that it’s different depending on your income relative to your home. If your home is inexpensive relative to your income, then playing with ARMs is no big deal. Otherwise, best to go 30 year and use the cash flow for long-term savings. You avoid interest rate risk, and build a BK/litigation shelter for wealth.

You’re the one focusing on the minute point of a shelter. I also made the point that mortgage interest creates a synthetic Roth for wealthier people. As someone who comments about how it’s unfair wealthier people can’t Roth and as someone who talks about breaking the law to get unemployment benefits, I thought you might appreciate legal income and tax strategy. It’s quite a divergence from your insistence that everyone should game UI for what is far less of a net gain than the strategy I suggested. Build a model with a spreadsheet and see what you actually stand to gain by paying mortgage interest in the long haul.

And to your last point – sure, equities should beat your ARM pending that rates do not go up. It all goes back to point #1 – it’s not as big of a risk if you have room for clearance between your ARM and monthly cash flow. If rates go up to your max, you likely won’t beat equities.

If it’s not a big deal, then it’s not a big deal. I personally like the idea of letting a bank hold most of the risk in the value of my home while giving me nearly-free money to accept that risk. I know you’re against the idea of walking away from a home, which is an interesting inconsistency given that walking away is entirely legal and within the risk-model for any banking institution, yet supportive of people who illegal use unemployment benefits for a small amount of money. Where’s the consistency?!

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Most people take the 30 year mortgage because the payment is lower. You always have the choice to accelerate the mortgage, but few do. When I refinanced, I went with a 15 year mortgage and I am accelerating it so it will be paid off by the time I retire. It takes discipline to actively work on reducing debt which most people do not have. They just let the payment schedule dictate their obligation.

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Financial Samurai Reply:
May 2nd, 2012 at 12:06 pm

Larry, we’re talking apples and oranges. The loans Im referring to are all 30 year amortizing. They just have fixed rates at shorter periods of time eg 5 year, 7 year, 10 year.

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I got in a 5/1 ARM back in 2003. Unfortunately, my loan also had a FLOOR of 6%, which was the into rate at the time (I was still in grad school at the time and was a little more aggressive/risky back then…).

It hasn’t gone up though since it reset a few years back, but we’re at 6 month libor plus 5% with a floor of 6% so we’re looking into refinancing to get that down.

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Financial Samurai Reply:
May 2nd, 2012 at 1:19 pm

Oh my goodness. A FLOOR of 6%? That is the biggest spread I have ever seen! What was your initial locked rate? I remember 6 years ago as rates weren’t that high, even for a 30yr fixed JUMBO.

Pls refinance.

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Nick Reply:
May 2nd, 2012 at 1:58 pm

It was a TERRIBLE loan (not as bad back then but still bad). A jumbo ARM. The initial rate was also 6%. The cap is 12%. We’re definitely trying to refi. Unfortunately I have a business partner on that property, which mucks up the process. (the partner part was the mistake in many ways – we still get along fine, but only because I have a very strict “I signed up for this” attitude.)

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It’s been tough for me to refi because I have an investment property. Although my rate is higher I have raised some rents and applied for a tax appeal. I have 5 comparables that should help me win and lower something if not my mortgage rate.

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Sam,
Your tone is pretty condescending and “all-knowing”, portraying anyone in a 30-Year as a schmuck, but there are several fallacies or assumptions that you purport to be factual which you may want to rethink.

“From this simple chart, you will understand:
* What the risk free rate of return is.
* Expectations on interest rates.
* Expectations on inflation.
* Borrowing/credit costs.
* Risk aversion, or lack thereof.
* The health of the world.”
==> At certain times, economists draw their own conclusions from the 10-year on some of these things, but by no means are any of your bullets crystal clear. For instance, was the world any more or less healthy a few months ago when the yield was much higher? How about Spain? Their sovereigns are spiking and we live in the same world. Risk aversion? The stock market has more than doubled since the financial crisis – that’s risk aversion? What’s really going on here is artificial manipulation by the Fed via various QE programs, Twist, etc. I can’t believe you’d actually pretend the current Treasury market is a non-manipulated free market like it was in preceding years.

“A large part of it is because the media and mortgage officers continue to push people to get as long a fixed rate mortgage as possible.” ==> Why would the media care what type of mortgage people held? And many banks make their business solely on short-term ARMs. Look at ING, one of the biggest! Every rate table I see shows all options and lets the consumer choose. There aren’t discounts or penalties for short vs long duration loans. This may be your own interpretation for whatever reason but not something I see in the market.

“* Adjustable rate loans have an interest rate cap. People think, thanks to fear mongering by the media and mortgage officers, that once the adjustable rate loan period is over, your mortgage rate will skyrocket and make things super unaffordable. This is not the case because everything is relative and rates are capped. I’m refinancing to a 5/1 ARM at 2.625% with all fees included, and after 5 years, the interest rate can reset one time to a maximum of 7.25%. Whoopdee doo! After 5 years, if I don’t pay any extra principal, my principal mortgage amount is about 10% less. A 7.25% mortgage rate on a 10% lower principal amount is very digestable.” ==> Most of the ARMs I’ve seen have a 2% increase over 3 yr allowed for +6 but for sake of argument, let’s use your 7.25% example. For whatever reason you only look out another 5 years, but I plan on living in my house another 25 or whatever. So, would you rather pay 2.625% for 5 and 7.25% for 25 more (in the event rates went up and didn’t come back which is entirely plausible) or pay like 4% for 30? I’d much rather take the latter.

“Higher demand is a reflection of a stronger economy, and your real assets (property), by very definition or inflating! So what if inflation rises from 2% to 5%, causing your mortgage to reset to 7% due to the 2% spread? If your home is now inflating by 5%, and you have a 80% loan-to-value ratio, your cash on cash return is going up by 25%!” ==> Several issues here. So, in periods of hyperinflation, there is no guarantee that property prices will appreciate. In fact, the very opposite could happen and in real dollar terms your “investment” is devalued. When high unemployment (which we have now, especially in your beloved CA) is combined with high inflation, home prices can actually plummet. The notion that home values will always increase during inflationary periods is a fallacy. Additionally, you cite a cash return, but for a primary residence, unless you plan on selling, it’s not an investment. You can’t tap that money (or shouldn’t); you have to live there!

“* 30 years in a row of deflation. Look at the historical 10-year treasury yield. Rates have gone down for 30 years in a row. That’s right folks. THIRTY YEARS! Are you telling me there’s no trend here? Are you saying that we are going to see massive inflation spikes on the way (which are fine as I just wrote) all of a sudden? ” ==> We have not had 30 years of deflation. What you are looking at is a secular trend of declining interest rates, but not deflation. We are not Japan. If you don’t think inflation can creep up quickly you are naive. All it would take is China dumping Treasuries, the dollar would plummet and we’d have massive inflation.

Of course, if people could always predict how long they’d be in their home, they would choose a mortgage term that matches. Things change though. People get laid off, divorced, want a bigger house…or nothing happens and they stay. It’s tough to predict with 100% accuracy.

“$96,250 more in interest expense ” It drives me nuts when bloggers talk about future dollars in the present. This is $13K in future dollars, not present dollars; you should discount back to give an apples to apples number.

“BenGenie has telegraphed the Fed Funds rate will stay at current levels until end of 2014. I believe him, and so should you. ” ==> Nobody should believe the Fed, the administration or politicians. They all say what’s necessary to maintain calm, affect markets or win elections. The MARKET will dictate interest rates in the coming years, not the Fed.

I guess in closing, if it matters, since you asked, what did you major in?

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Financial Samurai Reply:
May 2nd, 2012 at 2:37 pm

Darwin, just because the you’re losing our bet and the 10-year is back below 2%, you don’t have to get all huffy now! :) If you are happy with paying more every month in your 30-year fixed, so be it.

I think you mentioned you were trying to sell or are having a hard time selling, which may imply that refinancing is not an option due to the LTV? If so, I understand that is frustrating, and I’m sorry. What is your rate and duration now?

The tone of the article was inspired by a response from a “mortgage specialist” who wrote a book on mortgages. I received an e-mail from her asking me to promote her book. I congratulated her and mentioned I had just refinanced a 5/1 ARM at 2.625%. “Oh, no! You can’t refinance to a fixed rate???? That sucks!” I couldn’t be more disappointed with her response and her subsequent reasoning.

I majored in economics in undergrad and real estate and corporate finance in grad school. You?

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Investor Junkie Reply:
May 2nd, 2012 at 3:40 pm

This is why I never trust economists or weathermen:

http://investorjunkie.com/7723/trust-economists-weathermen/

:-)

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Darwin's Money Reply:
May 4th, 2012 at 1:41 pm

Sam, per our online and email exchanges, you can’t “propose” a bet and then claim I acepted it. You know my terms and you did not accept them so let’s move on unless you accept the terms I counter-offered. Anyway regarding other comments –

I was considering a move over a year ago and when we decided to stay (really more for school/emotional reasons than financial), I paid cash for a pool north of $60K, so no, I’ve never had issues with LTV or cash. Yes, I refinanced a few years back into a 30 at 4.625% which was a great rate at the time (and decent for now, but of course, could refi yet again into probably 4% or take a shorter duration loan with even lower rate).

Although majors are overrated and barely anyone these days works in a field that actually requires what they learned in their undergrad, I was Chemical Engineer, then MBA in Finance/Biotech.

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myself Reply:
May 7th, 2012 at 8:12 am

I must say that I have to agree with Darwin’s premise of people talking about future dollars in the present.
However, a quick PV calculation would show that a 30 year difference with future cost of $96,250 but the PV being just about $13k, would come to a rate of about 6.875%. So I guess I’m asking what formula Darwin was using to get PV of $13k for an FV of $96k?

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myself Reply:
May 7th, 2012 at 8:17 am

FWIW, I just started a refinance of our current 15 year note @ 4.625% originally, down to another 15 year @ 3%. Why? Well, because it alleviates about $290/month from required mortgage payment which we may continue to pay (if we do, it’ll pay the mortgage off 1 year earlier than our existing mortgage. We may opt to pay down our remaining consumer debt first, but that’s still in negotiations. :-)

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myself Reply:
May 9th, 2012 at 12:40 am

As an addendum to this, I just figured out (because I could), that the amount of interest we’ll be paying with the newer mortgage is dropping by 29.56% in the first month due to the refinance. And while the amount of principle paid down will be 3.1% less I’m ok with that. Especially when I compare where we will be at with our current note, in comparison to our original note @ 8% 12 years ago! If the numbers work out well, we may even take the offer for 2.875% on a 15 year note (which would pus the interest paid each month down by 36.5%+)! I just need to evaluate the additional costs to see if it is worth it to us.

Jai brings up a great point. You assume you’ll be always able to refi. There are cases where people have not been able to refi because of mortgage to equity ratio. If rates go up, is it safe to assume prices on houses could go down?

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Financial Samurai Reply:
May 2nd, 2012 at 2:38 pm

Only in stagflation. Rising rates are a symptom of something greater, rising asset prices eg your home, goods and services.

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Investor Junkie Reply:
May 2nd, 2012 at 4:06 pm

Rising rates in Greece, Spain and Italy meant their economy was getting better??

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Financial Samurai Reply:
May 3rd, 2012 at 12:49 pm

The USD is the world reserve. We can do anything we want, the US is that arrogant and powerful.

Investor Junkie Reply:
May 3rd, 2012 at 12:50 pm

Yes it is, until it’s not.

Fascinating post, Sam, thank you. I’m somewhat embarrassed that I hadn’t given the issue much thought. I’m still probably 1-2 years away from buying (sigh, Bay Area housing prices), but I had never seriously considered anything but a 30-year fixed. I’m not certain what the correct choice will be, but the 5/1 ARM looks quite reasonable.

I think my leaning towards the 30-year fixed has three sources:

1. Traditionalism. It’s the loan my parents had, and I feel like it’s described as the standard option in most things I read (casual reading, not serious research). This is a very bad reason :-).

2. Risk aversion. Since a house will probably be my biggest financial decision, as well as being a not-entirely-liquid asset, plus a large fraction of my income, plus being the place I live, I’d like to be able to guarantee that I’ll be able to continue living there. (I can poke holes in this argument, of course. It’s only semi-rational.

3. Complexity aversion. ARMs seem more complicated than fixed-rate, and I have a natural suspicion of complexity. I generally think the benefits of increased complexity accrue to the person whose day job it is to study the complex system in question! Since my day job is not real estate, it feels less risky to follow conventional wisdom. (Again, a sub-rational argument, but I’m trying to give you a psychological profile here, not a logical analysis!)

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Most people get 30 year mortgage due to sales tactics used by the mortgage brokers. As you’ve written in this article, mortgage brokers often cite the reason that having 30 years mortgage allows you to 1) qualify for a bigger house(more debt) and 2) you have less stress due to lower payment(again more debt). And you can always pay extra(most don’t). They get handsome commission for doing that. It’s no different than those insurance agents selling universal life(worst product devised in the history of scams).

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Most experts have said for years that rates would rise dramatically. WRONG. The only problem with most ARMS is they are tied to LIBOR, which people don’t follow, so people have to be a aware of what their ARM is tied to.

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Your reasoning is sound, but for the risk adverse it’s SO hard to fight against the peace of mind of locking it in for the long haul. We wasted ~$600 to refi from an ARM which we used to buy our first house into a fixed loan only to sell the place a year and half later…before the ARM would have adjusted…and if had adjusted it would have adjusted lower. Oops – live and learn.

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Financial Samurai Reply:
May 3rd, 2012 at 3:32 pm

Oops. At least you helped the economy with more income for the mortgage loan officer and bank!

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Sam, great post on challenging the status quo. There are two reasons why people take out 30 year mortgages.

1. Comfort (Risk Averse). People would rather pay more than deal with the fear of an increasing rate (peace of mind)

2. Maximize profit (Loves Risk): At a 30 year mortgage at 4%, I can use the lower mortgage payment to invest in real estate. Currently I make 18%+ in real estate so the lower principal payment is worth it for me.

You can use the Tax-equivalent yield formula to find out if your investment makes sense.

Tax-equivalent yield = Tax-free yield / (1 – your federal tax bracket)

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Most of our banks are not even offering fixed rate mortgages at all, much less 30 yr fixed. I confess to being somewhat conflicted when it comes to this topic. I personally would prefer fixed rate mortgages for the peace of mind, but can’t swallow the maths. The amount extra I would have to pay is mind boggling. However getting letters from the bank telling me that rates have risen AGAIN still makes me yearn a little for fixed rates.

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Financial Samurai Reply:
May 3rd, 2012 at 8:06 am

If only people in America knew that everywhere else in the world, the common mortgage is a yearly floating subject to change. Sigh.

Everything is relative. And, I’m sure if folks in Singapore were able to lock 5 years, they would call a 5/1 ARM a fixed rate mortgage b/c it is, for 5 years!

Let’s not even talk about mortgage interest tax deductions….

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I just closed on my house, and for my loan option I chose a 15 year. The lady I was working with really tried to push us into a 30 year note, but I wasnt going to back off from the 15 year. I know that it may not be the best option out there for me, but it was the one that I was most comfortable with and if something changes, I can always refinance the note.

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Financial Samurai Reply:
May 3rd, 2012 at 9:12 am

What rate did you get? I don’t mind a 15 year term at all if one can swing it. Not sure what JT is so against w/ the 15 year.

How long did yours take?

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Sam, we just started a 15 year refinance at 2.875% for our house. We were going to pay off our house early in 6 years (at my 40th birthday), but with this kind of rate, we decided to free up cash and start investing rather than dumping it into the house- hence the refinance. The closing costs are only about 4K, which is doable and we’re planning on living in our house as long as we can. Thanks for your article here.

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Financial Samurai Reply:
May 3rd, 2012 at 9:13 am

Great rate, but expensive closing costs! Have you done the break even math on closing costs? The irony is the bigger your mortgage, the more digestible the closing costs.

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Yes, the break even will be 3 1/2 years, which we’ll still be in the house. We’ll have a little punch to the gut in the short term, but long term, we’ll have about $1,700 freed up a month in cash to invest in stocks, bonds, and other areas, or to splurge on steak dinners, and the investments I think will generate much more than 2.875%.

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Financial Samurai Reply:
May 3rd, 2012 at 12:52 pm

Hmmm, OK. Don’t move beforehand OK!

I always advise my clients to shoot for a MAX break even period of 12 months.

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Jeremy Noel Johnson Reply:
May 3rd, 2012 at 1:21 pm

That is good to know Sam – is that break even period based on an average amount of time people move from their home?

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Financial Samurai Reply:
May 3rd, 2012 at 3:33 pm

Yes, and the frequency of refinancing, rate movements, and so forth.

Another enjoyable post Sam. This relates sort of what I am debating at the moment so maybe you and the readers have some words of wisdom. I am looking to purchase a home, nothing big just a little condo since I know my wife and I will want a bigger home or to move out of the country within 5 years. Thing is we have cash to pay for the homes we are looking at. Again nothing expensive 2/2 condo to put a little sweat equity into and then rent out. But my question is should we pay cash for it or take out a 5/1 arm loan. I mean why pay any interest at all if we have the cash? Some say pay cash others say use the banks money but paying interest when I have the funds seems to be giving the bank money in my opinion.

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Financial Samurai Reply:
May 3rd, 2012 at 12:51 pm

Leaving in 5 years?

Buy nothing and keep renting.

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Thomas - Ways to Invest Money Reply:
May 4th, 2012 at 11:51 am

Hey Sam,

Really you say buy nothing but I think it would be a great income source for rental.
If we rent for another 5 the money we spend rent would cover the cost of the condo.

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Financial Samurai Reply:
May 4th, 2012 at 11:53 am

OK, if you don’t plan to SELL in 5 years, then definitely buy. Rental properties look so attractive right now!

Thomas - Ways to Invest Money Reply:
June 11th, 2012 at 11:27 am

Yes that is the plan, NOT to SELL. We just want to have something completely paid off in the states. Since we plan to move or travel abroad(3-6 months at a time), we figure no need to waste interest at the most get 5/1 ARM and have it paid before the arm adjusts.

Financial Samurai Reply:
June 11th, 2012 at 11:52 am

Sounds good. Furthermore, as thousands of ARM holders have discovered over the past….. 30 years, ARMs have been adjust DOWN!

Sam,

I am not sure I understand why you say they didn’t get in trouble? A lot couldn’t refinance b/c the house was worth less than the mortgage…so yes, they got in trouble not b/c of rates but because of the value of the home

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Financial Samurai Reply:
May 8th, 2012 at 9:59 am

We are talking about a decision between a 30-year fixed and a 5/1 ARM, or ARMs in general. It’s important to focus the conversation on the topic at hand, which is not wasting money on paying more interest than one has to.

With your line of argument, one can say people get in trouble because they didn’t study in school, or were simply born.

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Evan Reply:
May 8th, 2012 at 5:43 pm

I am not sure I understand the analogy. You are saying the math is fantastic so everyone should consider it – but all I did was bring up the very valid point that the risk is that refinancing is hard (house value goes down) or impossible (job loss).

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Financial Samurai Reply:
May 8th, 2012 at 6:21 pm

What I’m saying is that it is important to compartamentalize issues and not confuse various variables.

Hey Sam,

it’s very interesting to see how mortgages work in US (it’s very different in Canada). I have 2 questions:

if you take a 30 years fixed mortgage and you sell your house to buy another one after 7 years, what happen to your fixed, can’t you just keep it and transfer your mortgage to your new house? We don’t have 30 years fixed option in Canada, but if you have a 5 year or 7 year term and change house prior to the maturity date, you can simply keep your contract and apply it to the new house without any penalties.

why do you wrote the following:
“So what if inflation rises from 2% to 5%, causing your mortgage to reset to 7% due to the 2% spread? If your home is now inflating by 5%, and you have a 80% loan-to-value ratio, your cash on cash return is going up by 25%!”

here’s the situation: you buy a house at 100K. The price increase by 5% due to inflation. The new price will be 105K. You didn’t make a penny: if you sell your house to buy a another one: all the other houses have increased by 5%. Where is the gain?

You only “make” money if you go back in an apartment, but you are comparing apples to oranges. In this situation, you don’t make money but you save money as you are downsizing your lifestyle.

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Financial Samurai Reply:
May 6th, 2012 at 7:02 am

Some mortgages are assumable, many are not.

The mortgage is based on the collateral value of the house and are most always sold off in the mortgage backed securities market, hence, a need for a new one.

Yes, of you only own one home you are net neutral property. Need to own two or more to be long. Renters are short.

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If you look simply at the mathematics and calculate the interest rate, then increasing the mortgage period implies increased additional payment for interests. The math might also confuse the others as the monthly payments will tell you otherwise(lesser monthly payment for 30-year mortgage).

The most common factor why individuals opt for 30-year mortgage loan is the salesman. Because of the cognitive bias that we naturally have, the salesman tap our beliefs to conform with what he is selling. And salesman don’t tell lies but they don’t tell the whole story as well. Take for example the recent news that mortgage rates declined because more sought financing for house purchases. The average rate for 30-year fixed loan fell to 3.9 %. The word “fell” or “reduced interest” or anything that implies the same will most often than not catch the attention of a buyer.

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I like the 15 year note. 15 years feels to me like something I can complete. 30 years is hard to visualize. The concept of taking the lowest rate available has two drawbacks not mentioned here: 1) the cost of refinancing 3 or 4 times over the course of time compared with staying with the same mortgage can negate some of the savings; and 2) the reduction in interest payments also means less of a tax write-off which is fine however if you’re using the savings from a lower mortgage payment for discretionary spending then you are not really gaining anything. Few people reduce their mortgage payment in order to increase investments.

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Your mortgage loan officer quiz is a good one: a real mortgage officer should be able to answer those questions and more. They should also be in it to help you get what you want and what works for you, they should not be in it to jeopardize your future.

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Just wanted to say I love your blog – I’m a new reader and you really opened my eyes on a lot of things. Keep up the great work.

I’m going to be in the market for a house in the next 6 months and am now considering the ARM loan. We are looking for more of a starter house. How long would you recommend one lives in a starter home before it makes sense to sell? Sounds you think it should be 5 + years? We are looking for a fixer upper that we can put some sweat equity into. Thanks – Ryan

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Financial Samurai Reply:
June 23rd, 2012 at 1:00 pm

Thanks Ryan. How did you find my site?

I really recommend NOT buying if you can’t see yourself in your home for at least 5 years due to the selling costs.

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Hi Sam, Very Interesting blog.Here is my situation.Hope you can guide.I closed one House deal for 157K .Closing date is 27 july. Interest rate I locked is 7 year ARM for 2.625 ($602 monthly installment /1120 (including tax etc)) . Mortgage officer gave me option that I can change it to 30 years fixed for rate of 3.5% ( $672monthly installment/ 1190 (including tax etc)) by 13 th July. 7 year ARMS will save 4289.4 in 5 years installments and make additional contribution of 2127.55 towards Principal.Do you think this difference $70 /Month is really considerable ? I am not sure for how long i am going to stay in this house but I have already spent 4 years in renting ( $900 per Month ).Thanks.

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Financial Samurai Reply:
July 8th, 2012 at 8:08 am

I’d keep 2.625%.

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Another idea is an interest only adjustable rate (1 month or 6 month LIBOR); converts to amortizing after 10 years.

1 month variable rate is about 1.875%
6 month variable rate is about 2.50%

You can pay principal at anytime and your mortgage balance/ payment is adjusted monthly to reflect the new lower balance.

Good if you plan to be in the home short term. Even lower interest costs than a traditional 5/1 ARM.

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I would not finance less than a 30-yr fixed because the ROI on home equity is horrendous. Anything less than 30 yrs requires too much home equity accumulated too quickly. My money works far harder (and/or smarter) in the stock market or as a down pmt on a rental property than it does in my primary residence. A house, to me, is one investment — the cost of a roof over my head, and the calculation is owning versus renting. The competing ROIs from other investments, and my desire for diversification, have led me to this financially sound, educated calculation: have as little net worth tied up in my primary residence for as long as possible.

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Financial Samurai Reply:
August 6th, 2012 at 9:47 pm

Huh? Are you getting things mixed up? I’m talking about fixing an interest rate for as short a duration as possible to take advantage of the lowest interest rates, since inflation isn’t going up.

I’m not talking about borrowing for 5 years and paying it all about in 5 years. I’m saying borrow at a 5 year or less fixed rate, that still amortizes over 30 years.

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OK, I decided to crunch the numbers since you re-posted this. Please feel free to challenge me on them and prove me wrong.

$275,000 Mortgage – I used this because the average is around $225,000, I believe. That $1,000,000 you throw around is lunacy – you need to get out of SF/Hawaii/NYC more often.

30 YR Fixed at 3.5% – 1,231/month – (let’s add a little extra) – $1,500/month =

$119,000 Total Interest – Pay Off In 260 Months

5/1 ARM at 2.5% – 1,084/month – (let’s add a little extra) = $1,500/month =

$30,823 Interest – After 60 Months

30 YR Fixed at 5.5% on $215,000 (new principal) – (let’s add a little extra) = $1,500/month

$135,938 Total Interest – Pay Off In 236 Months

Total Interest With ARM Plan = $166,761
Total Interest With Fixed Plan = $119,000

How exactly is bearing the interest rate risk worth it again? I just don’t follow you on this one.

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Financial Samurai Reply:
August 7th, 2012 at 9:37 am

Hi Mate, sure. Your math is wrong. Check your calculations and redo. You’ll see.

Cheers

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MacroCheese Reply:
August 7th, 2012 at 10:12 am

Which part of my math is incorrect?

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Financial Samurai Reply:
August 15th, 2012 at 8:33 am

2.5% < 3.5% < 5.5%

If you pay a 2.5% rate, you are obviously paying less interest than if you a 5.5% rate. I really am not following you. It’ so simple.

You don’t have to justify to me paying a higher rate 30 year fixed if you it makes you feel more comfortable at night.

I’m just telling you that you are paying more to the banks to eventually own your home than necessary, as has been shown for the past 30+ years.

Here’s a nifty little tool I found from Credit Sesame: http://www.creditsesame.com/mortgage/mortgage-calculator/

Enter your information (including loan length and closing costs) and it will come back with several options which can be sorted by interest rate or monthly payment vs. “true cost”. It works for refinance and purchase.

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I cannot agree more with this post. I try to not mention too many of my financial goals with people I know but recently it came up that I am buying a house within a few months. What this meant was people asking me what loan I was getting and I invariably answered a Conventional 3/1 or 5/1 mortgage. Having to explain to others the positive expected values from allowing the mortgage issuer to float the interest was difficult.

Very simple thought exercise who are severely on the 30 year-conforming track:

Take a 30 year mortgage (let’s just say 3.6%) on $200k loan ($909.24 payment) and look at your principal after five years: $179,701

Take a 5/1 ARM (let’s say 2.5%) on $200k loan but instead of the minimum payment, pay what the 30 year mortgage payment would have been ($909.24). After five years, your principal is: $168,554

Making the same exact payment saves you over $10k over that time. At that point it is entirely possible to refinance into a mortgage if payments become difficult. By the way, do not take this as an endorsement to aggressively spend down a 2.5% loan (above the minimum payment). I would personally the exact opposite!

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Financial Samurai Reply:
September 7th, 2012 at 8:45 am

Right on man! I think you are doing the right thing and are also timing the housing market well. Just make sure to hold onto your house for a long time to create great wealth!

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I am debating b/n a 5yr ARM @ 2.5% vs a 10yr ARM @ 3.125% for a high cost conforming loan. I do expect to live in my house for atleast 7yrs…likely even more. I am tempted to do the 5:1 ARM even though 10yr ARM is likely the safer bet

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Financial Samurai,

I stumbled across this blog looking for information as I am refinancing. A lot of great information so thank you. I was hoping you could help between 7/1 or 15/30 year fixed. I am refinancing from a 30 year fixed that was at 5.5% with Principal of $480,000. I can refinance with a 30 year at 3%, a 7/1 at 2.75% or a 15 year at 3%. At this point we do not know how long we will be in our house but it is a house we could see ourselves in for a long time. Any insight or thoughts would be great.

Thanks,
Mike

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Financial Samurai Reply:
September 13th, 2012 at 9:31 pm

Mike, the spread between 3% and 2.75% is way too narrow to make a 2.75% worth it imo. Hence, I would refinance to a 30year at 3%, and keep the flexibility of more cashflow over a 15 year fixed.

Welcome to the site! You can check out all my other mortgage related posts here.

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Patriot34 Reply:
September 14th, 2012 at 8:17 am

Financial Samarai,

Thanks for the answer. I apologize I inadvertently typed 3% on the 30 year but it is 3.875%. Sorry about that. I will check out the other info. Let me know if this changes your thoughts.

Thanks,
Mike

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Great analysis. This pretty much matches the numbers that I ran when comparing a 7/1 ARM with a 20 year fixed mortgage.

After you factor in even a modest 3-4% after tax appreciation on the monthly savings, the breakeven point for the 7/1 w.r.t to the 20 years is 10 years. One just has to be disciplined about putting that money away where it will grow.

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Toddius Reply:
October 29th, 2012 at 6:02 pm

I fully agree with you. I worked it out in a spreadsheet assuming the worst possible case as far as interest increases go. I can get 2.75% with a 5/1 ARM and 3.5% with a 30-yr fixed. The 0.75% saves me about $200/mo. If that difference is saved ($12,000 after 5 years) and invested, with even a modest 3% R0I your savings continue to go up after the 5 years. I encourage everyone to sit down and do the math.

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Toddius Reply:
October 29th, 2012 at 7:46 pm

Sam,
I realized I made a mistake in my calcs. Please do not post my comment. But I will agree that it works out in the short term. Then you have to ask how will the rates change in the long term.

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I just re-financed to 10/1 ARM for 3.125% and then found your site. Is that a good deal? I went with BofA which did my original 30 yr fixed at 4.75% two years ago. Maybe I should have gone with Quicken, but are they just as trustworthy/have as good customer service?

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I don’t like the 30 year FRM or ARM. I think they are both a bad idea. Committing to 30 years of payments is nuts and choosing an ARM adds unnecessary risk.

Get a 10 or 15 year FRM. You can get close to the same rate as a ARM with a 10 or 15 year FRM. Your payment will never go up and you can refinance in the future if they go down. If you can’t easily afford a 10 or 15 year FRM then the home is probably too expensive for you.

I also wouldn’t recommend buying a house if you don’t plan on staying there for at least 10-15 years. There is a good chance you will lose money in the short term with fluctuations in the market and real estate sales fees. Renting is typically much cheaper in the short term.

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Hi Sam! I currently have a 4.75% 30yr. on a 990k loan. I am looking to refi this week. We will be in our home for at least 10years. My current rate rate offerings are as follows:
30yr.fix @4.35%
7/1 ARM @3.50%
Closing costs roughly $2700
I’m waiting for my accountant to call me back but wanted to hear what you have to say as well. Also, concerned with losing more mortgage tax deduction by going with a lower rate. Any thought?

Thanks in Advance!

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Financial Samurai Reply:
January 10th, 2013 at 11:15 am

Hi Angelo,

My first recommendation is to check online for a better rate with Quicken Loans. It’s free and there’s no obligation. I always check with them b/c they don’t have the overhead as big bricks and mortars banks do. Therefore, I’ve found their rates to be lower. The other thing is they are more streamlined in their refinance process.

I honestly don’t think 4.35% is that great for 30yr fixed jumbo. I’m in the process of completing a free loan modification and mine is at 4.25%. If I were to refinance, I’m sure I could get 4.125% or lower.

Keep searching. Also, consider a 5/1 ARM instead at under 3%.

Sam

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Angelo Reply:
January 10th, 2013 at 3:27 pm

Thanks Sam for responding so quickly. I called Quicken loans and they only finance up to 60% on Jumbo Loans.

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Financial Samurai Reply:
January 10th, 2013 at 4:32 pm

Must be case specific, as I checked online and they are up to 80% LTV for me and other friends.

It’s because I need a 90% LTV mortgage.

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Financial Samurai Reply:
January 10th, 2013 at 7:17 pm

Gotcha. Any thoughts on paying down the mortgage to make it 80% LTV to lower your mortgage? If u plan to live there for more than 5 years, and didn’t overbuy then that’s what is do.

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I bought just over a year ago when the market was very poor. ;)
Much of money is tied into investments. I may just go with the 3.50% 7/1 and use the money I’m saving to pay down the principal.

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Hi everyome, I am 1 week tp close everything for my first

I am so confuse, i chose the 15 year loan with a 2.875% 0 points and no penalties for paying it off before time, or ballon payments. Now, the lender just asked me this

We are already locked at 2.875% with a 1.9% credit so there aren’t any points, underwriting or processing fees. Here are some options:
Current credit to you is $2675 2.75%, lender credit will be reduced to $1689 (by $1k)
2.625%, lender credit will be reduced to $994
2.5%, lender credit will be reduced to $290

Our loan is 140.800 usd since we are doing a 20% down payment. We dont mind paying a bit extra at closing, we just want the best deal but i am so confused
Our payment will be 963+ 304 of taxes and insurance. How does this sound to you? 1268 usd per month. We just got married, no kids.
Our current rent is about same as our future mortgage so we thought it was a good idea to buy a home.
Please help me, We can pay up tp 1500 usd per month, around 50% of my husband salary. Thanks Daniela

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Sam, As I am in the midst of buying my first home I always keep coming back to this article to ensure I am making an informed decision.

If I live in CA which is a non-recourse state (based on your other article) would re-financing a loan not turn it in a recourse loan? Isnt that a reason why one should NOT get a ARM since refinancing is inevitable?

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Financial Samurai Reply:
January 20th, 2013 at 12:31 am

Recourse means that the lender can sue you for the deficiency. In CA, if the lender forecloses your house, they have just exercised the “one action rule”. Therefore, they cannot come after you for the deficiency.

So 1) sue for the deficiency, or 2) foreclose. Pick one. That’s why they call it “one action rule.”

ARMs don’t have to be refinanced. Once the fixed rate is up, you can let float. It’s the HELOCs and cashing out out refinances that put your other assets at risk, not your primary. Check with an attorney.

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Sam — I am looking to use a 10 year fixed rate (w/ 30 year amoritization period). I just want to make sure that I will not be paying more interest during my 10 year fixed period than if I chose the 30 year fixed loan product. In other words, if my monthly payment would be $3K on the 30 year fixed conventional and $2900 on the 10 year fixed, is there any difference in the amount that is applied towards principal during the first 10 years of the 30 year fixed option? My inkling is that there is not, but I thought I would pick your brain.

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Adam Reply:
May 19th, 2013 at 6:12 am

In order to figure out interest; what is the rate?

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Greetings,

contract 771,500…..20%…loan 617200- 10/1 arm 3% and 30yr fixed@3.75% options…….. planning to live for around 15 years…. have kids <1 and 8 yrs old and moving for a good schools till high.

Non-conforming loan and would reset by 5% (max) in 2023. county limit 494,500 so don't qualify for conforming rate cap of 2%.

loan is tied to index and margin of 2.3% approx for the 10/1 ARM.

financially stable and will earn more in coming years with progress and promotions. please advice.

please let me know if you need any additional information.

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I am new to this arena, so I had to look up the term Adjustable Rate Mortgage. For anyone that is interested, I found a good definition here https://realestatemetro.com/real-estate-terms/adjustable-rate-mortgage.

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Sam when I stumbled on this article I did not believe you either since it goes against everything we’ve been told over the years, “LOCK IN THESE RATES NOOOWZZ!!”

But I did the math for myself; and even taking account rolling all costing costs and points into the refinance; I would still come out AHEAD by at least 10% on principal after 5 years AND my worst case rate increase monthly payment would be LESS than what it is now.

The math just blew my socks off and I’m going to refinance from a 3.75 30 year fixed to a 1% APR. Infact going to refinance all my properties to 5/1 ARMs.

This is one of those things where I need to tell all my friends and families about.

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Financial Samurai Reply:
May 16th, 2013 at 5:09 pm

The beauty is, you may not even have to refinance and let your rate float at current levels. A 3.75% 30 year fixed ain’t bad, but if you can get a 1% APR, then wow… very tempting!

Doing the math always makes a lot of sense. Too much blind faith. Good luck!

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