News:

To return to the forum homepage, please click the banner at the top of your browser.

Main Menu

ARM still the wisest choice for a mortgage?

Started by Sir Aaron, November 24, 2018, 10:48:07 AM

Previous topic - Next topic

Sir Aaron

My life has taken many turns. I moved from Los Angeles to Houston. At the time I expected to live in the house 3-7 years max. I was on the management tract which meant moving to Washington DC in 3-5 years (or somewhere else). 13 years later I find myself still in Houston.

Now my daughter is a national champion figure skater with the potential to go to the world championships in a few years time. Her partner lives in Florida so we are moving there so they can skate together and be under elite level coaching. So I'm selling my house and moving there.

So I find myself going from the downside of a 15 year fixed mortgage to taking on a bigger mortgage in a more expensive area (so I can be closer to work, school, and skating rink). The choices I have now are whether I should be taking an ARM on a jumbo loan or a 30 year fixed?

So my options are a 10/1 ARM at 4.125% or a 30 year fixed at 4.875% (Maybe 4.75%). I've locked the 10/1 in at 4.125%. I could pay a discount point and get the 30 year lower.

I don't know if this is my forever home. In 10 years my girls will be college age and I will likely be retired. Will I downsize? Will I move? Will I stay? I have no idea. What I do know is that interest rates are moving up and probably will do so into 2019.

My plan was to take the ARM and pay the loan as if I had the 30 year fixed. Then I'd refinance at some point to another ARM or to a 15/20 year fixed.

I guess I need some reassurance that taking the ARM is the best route.

jekamom

I personally don't like the risk of an ARM.   If rates go up (inflation) and wage power goes down, you are facing increased payments and lower purchasing power.  The rule I know is: if you qualify for a 15 year fixed, take it.  Keep it maintained.  Buy a little less than you need.  Better to have the least expensive home on the block than the most expensive.

Sir Aaron

I don't care for the risk either. And we are pretty sure the interest rates will increase at least over the next year.

But it's not really a case of the house price or whether I can afford a 30 year fixed vs. a 10 year ARM. I can afford either one. My plan is to do one of the other.

Take a 30 year mortgage and make the payments. Or take the 10/1 ARM and make payments like I would with the 30 year fixed (or invest the difference).

The risk I face is what do I do with the balance in 10 years. I can refi to a 20 year or to another ARM.

Sam

The wisest choice is to match the fixed duration with your expected ownership duration. 30-year Fixed rate mortgage is have been a bad deal for the past 30+ years as Mortgage borrowers paid 50 basis points to 150 basis points higher than they needed to as Rates have come down.

I don't think mortgage rates are going to go up by more than 50 basis points MAX Over the next 10 years. The yield curve is flattening, and yells her down today. If you plan to be there for 10 years, then the safest bet is to take a 10 year adjustable rate mortgage.

See: https://www.financialsamurai.com/30-year-fixed-mortgage-loan-vs-adjustable-rate-mortgage-arm-the-choice-is-obvious/
Regards,

Sam

Sir Aaron

#4
What if you don't know how long you will be there? It could be 10 years, it could be 15, or I could be there 20+ years. I simply don't know.

I mean the question is, if I plan to be there 20 years, am I doing the right thing taking a 10/1 ARM or am I better off with fixed?

polama

The rate difference between the 30 year fixed and the 10/1 ARM is what you're paying as insurance against the net interest rate difference from today in years 10-30 (or until you sell/pay it off).  In a house you're definitely staying at for < 10 years, that has no value. If you're definitely staying 30 years, it has maximum value. If you're uncertain, you just have to sort of weight the outcomes.

First, you should usually buy insurance for situations you couldn't cover yourself. If interest rates go up and the ARM starts hitting max increases, and you couldn't find a buyer, would you go bankrupt? Would you be jeopardizing retirement? If so, you should look closely at the fixed rate.

If that's not catastrophic, it comes down to how much is fair compensation for the risk, and that's sort of a question of your own risk profile and opinions about interest rate trajectories. In general, insurers make a profit so if you can self-insure (ARM) it's worth doing. But in a case like this, where the bank can amortize the risk much wider then you, they might have less risk aversion then you and the loss of risk is worth the cost. (Although again, you have to factor in the risk that you forfeit this insurance by selling soon)

Something to consider would be this: Rather than just paying off the ARM as if it was the fixed rate, can you boost your savings rate such that you'll have enough in savings/investments to pay off the house in 10 years? If rates aren't awful, great, you're that much closer to financial independence. If rates are awful, great, you're that much closer to financial independence and you can just make the mortgage go away.

Sir Aaron

I definitely can't pay the loan off in 10 or 15 years. If I could I would have taken a 10 or 15 year fixed.

My plan is basically to make payments on the 10/1 ARM as if I had taken the 30 year fixed. Then as I approach the tenth year or in the tenth year I would have to evaluate my options. At that point, if the rate is low enough I might be able to afford to get into a 15 year. If rates went a lot higher, then I suppose I could refinance to another 30 year loan or some other ARM product or whatever. I would be refinancing a much lower balance at that point.

The rise in interest rates wouldn't kill me. It would suck if they went up 5% in 10 years. The question really is, is the difference between 4.125% and 4.875% worth the risk? Not whether I can afford it, but whether its a good idea. I'm basically gambling that in 10 years, I will be able to refinance to a 15 or 20 year fixed at around 5%.

Eric

I would definitely recommend the ARM.

There is no point locking yourself into longer duration than you need. Also remember that you can refinance if rates go down, and there will probably be a change in the interest rate cycle from now until then.

Get a good mortgage calculator or build a robust spreadsheet where you can see the amortization. If you are paying 4.10% on the ARM vs 4.85 on the fixed and a new mortgage or your ARM resets to 5%, you are still very well ahead on the ARM. Remember that the interest rate is calculated on the principal amount outstanding. At year 10, your principal would be much smaller.

If you payoff the 30yr fixed payment on your ARM, you are making additional principal payments and shifting each future payment to be more principal and less interest (as your balance decreases). If you do this, I think the breakeven reset rate would be much higher,  probably 8-9% which I would think would be very unlikely before hitting a point where it made sense to refi. Also most ARMs have maximum reset rates, how much it can move at the first reset and then subsequent resets, providing additional protection in a rising rate scenario.

Sir Aaron

Quote from: Eric on December 02, 2018, 05:58:19 PM
I would definitely recommend the ARM.

There is no point locking yourself into longer duration than you need. Also remember that you can refinance if rates go down, and there will probably be a change in the interest rate cycle from now until then.

Get a good mortgage calculator or build a robust spreadsheet where you can see the amortization. If you are paying 4.10% on the ARM vs 4.85 on the fixed and a new mortgage or your ARM resets to 5%, you are still very well ahead on the ARM. Remember that the interest rate is calculated on the principal amount outstanding. At year 10, your principal would be much smaller.

If you payoff the 30yr fixed payment on your ARM, you are making additional principal payments and shifting each future payment to be more principal and less interest (as your balance decreases). If you do this, I think the breakeven reset rate would be much higher,  probably 8-9% which I would think would be very unlikely before hitting a point where it made sense to refi. Also most ARMs have maximum reset rates, how much it can move at the first reset and then subsequent resets, providing additional protection in a rising rate scenario.

Thanks for the advice.

The ARM is a 10/1 ARM. In year 11 it can adjust to the current rate up to the highest maximum rate of up to 9.125%. But whatever it adjusts to the first year, the maximum it can increase is 2% per year after that. The max is always 9.125%.

My plan was to either apply the difference between the 4.125% and the 4.875% either to the principal as time goes along or save it and invest. Either way, I figure by year 11, I will refinance to another ARM or to a 20 or 15 year fixed. Any of those three options will have at least a 1/2% lower rate than a 30 year fixed.