Archives for February 2008

After I made the decision to get a fixed rate mortgage over one with an adjustable rate, the next was to decide what length to get. I thought this would be an easy decision, but there are a surprisingly large number of variables to consider!

Viewpoint #1: Get The Shortest Mortgage You Can Afford
With a longer term, you build equity more slowly but have more affordable payments. With a shorter term, face higher monthly payments but you own the home faster and pay less interest. So the traditional advice seems to be: get the shortest mortgage that you can afford.

This is can be a slippery slope, though. 15-year too expensive? Let’s try 30-year. No? How about 40-year? Hmm… barely. Well, maybe that ARM isn’t that bad after all… Affordability shouldn’t be the only consideration.

Viewpoint #2: Get The Longest Mortgage You Can Afford
In my previous post 10 Reasons You Should Never Pay Off Your Mortgage, I explored the reasons why certain financial advisors tell people to get the longest mortgage they can get. Basically, your mortgage is a cheap, long-term loan. If you re-invest this money into stocks, which over the long run are expected to return much more than 5-6% annually, why would you want a shorter loan? It’s a great arbitrage opportunity.

If you believe in this theory, then your answer is simple: get the longest mortgage you can afford, as long as the effective interest rate is lower than what you confidently can earn elsewhere.

Viewpoint #3: Longer Mortgages As Paying For Flexibility
Here’s the thing. Just because you have a 30-year mortgage doesn’t mean you have to take 30 years to pay it off. As long as you don’t have a prepayment penalty, you can simply send in additional money towards your loan principal and pay it off in 8, 15, or 23.5 years. However, if you have a 15-year mortgage, you have to make those higher payments every month or risk losing your home. So going for the longer term essentially sets you a “minimum payment”, which you can exceed as you wish. This can make a big difference if I run into extended unemployment or other large financial setbacks.

Example: 15-Year vs. 30-Year + Extra Principal
Of course, as you get a longer term, your interest rate will also go up a bit. But if you run the numbers, it actually doesn’t make that much difference! Let’s say that the 15-year is at 5.125% right now, but the 30-year is at 5.625%. The 15-year payment is $2,392, while the 30-year payment is $1,727 – a difference of $665.

However, if I just paid the $665 extra toward the 30-year mortgage each month, I still end up paying that 30-year loan off in less than 16 years! In exchange for the safety and flexibility of lower minimum payments, I stretched my 15-year loan out for an extra year. I view this extra interest as insurance.

Our Situation and Final Decision
In the case of Viewpoint #1, we can currently afford the payment for a 15-year mortgage. On the other hand, subscribing to Viewpoint #2 this would leave us wanting a 40-year mortgage at a relatively low 6% rate. However, while I see the merits of the arbitrage argument, I don’t necessarily think it’s an apples-to-apples comparison when you have two things with different risk/return characteristics.

I ended going with the 30-year fixed mortgage, primarily due to the reasons explained in Viewpoint #3. I am not against paying off our house early – I actually like the idea of having my home paid off as it would help simplify our income planning in retirement. (I could also treat paying it off early as owning a bond.) However, the flexibility of being able to make the lower payments as needed was a big draw, especially given the relatively small premium for doing so. Finally, if we rent the house out one day, the lower payment would also help with managing rental cashflow.

So why not a 40-year mortgage here as well? As you go longer, the mortgage payment stops dropping very much. A 40-year loan would involve an even higher rate and only lower our payment by 4%.

Conforming loans are those that satisfy the criteria that Fannie Mae and Freddie Mac set regarding what kinds of loans they will buy. Besides certain credit-related guidelines like debt-to-income ratio, one major constraint is the maximum loan amount. Barring any upcoming changes (see below), the current limits are $417,000 in the continental US (AK, HI get $625,500).

Because they can be so readily sold to these psuedo-government entities, conforming loans are usually very competitively priced. Non-conforming loans have to be sold elsewhere or kept in-house, so they usually end with higher rates. But as recently as July 2007, the added cost for a non-conforming loan might have been only 0.20%. However, due to rising default rates and skeptical investors, the premium is currently around a full 1%. This has led to the increasing popularity of replacing a jumbo loan with two loans – a conforming one and a second loan to make up the difference.

Example. Let’s say you wanted to buy a $600,000 home, with a 20% down payment ($120,000). This leaves $480,000 to be financed, which is over the $417,000 conforming cap. With a single Jumbo loan, here’s your scenario. (I’ll use estimated mortgage rates based on current market conditions.)

But, here’s what happens when you split it up into a $417,000 conforming loan and a $63,000 second loan. The second loan usually has a higher interest rate, similar to that of a home equity loan.

By restructuring, you have lowered your effective interest rate nearly 50 basis points .from 6.5% to 6.01%, which in turn lowered the mortgage payment by $127 a month ($1,524 a year). To find the blended rate, I used the this Dinkytown calculator.

The Fine Print:

• This works best with small 2nd loans. Kind of obvious, but the less you have to put on the 2nd loan with higher interest, the better your blended rate would be. As the loan amount rises, there will likely be a point when the plain Jumbo loan will give you the lower payment.
• The second loan can be structured in a variety of ways. It could be a completely separate loan from a different lender, it could be a home equity loan from the same lender, or it could be a home equity line of credit.
• You might have balloon payments. In my case, I was offered a equity loan amortized over 30 years, but with a balloon payment due after 15 years. So I would need to either pay off that $63,000 within 15 years, or refinance before then.
• Possibly higher closing costs. The second loan may incur closing costs, but they should be a lot smaller than the first loan because things like appraisals have already been paid for.
• Conforming limits might change soon! The pending economic stimulus package legislation – which is almost on Bush’s desk as I type – proposes to temporarily raise the conforming limits to as high as $729,750 in “high cost” areas based on median home price. It is unknown how soon this will take effect, but probably too late for me. (Google News)

Before shopping for rates, we had to figure out what kind of mortgage loan we were going to get. The first decision was between a fixed-rate or an adjustable-rate mortgage. Quickly, here are some very general definitions:

• Fixed rate mortgages (FRMs) provide a constant monthly payment for the life of the loan, no matter what interest rates do in the meantime. Common lengths are for 15 and 30 years.
• Adjustable rate mortgages (ARMs) offer a lower monthly payment for a certain initial period, and then adjust periodically afterwards. Common initial periods are 1, 3, 5, and 7 years. For example, if you see a “5/1” ARM, the rate and payments are fixed for the first 5 years, and then will adjust according to a pre-determined formula one a year after that. A “5/5” ARM adjusts only once every 5 years. Usually they are also based on a 30-year amortization, but not always.

Here were my three main considerations for choosing between ARMs and FRMs:

How long do I expect to stay in the home?
I’ve read statistics that people tend to move about once ever 5-7 years, and that the average mortgage only lasts 7-8 years before being refinanced or paid off (usually from the sale of the home). But who cares about average? Everyone is different.

It’s true that if I bought a “starter home” that with the arrival of kids we might need a quieter neighborhood or more space. In our case, we ended up finding a home that has everything we need for the foreseeable future. While trying to be as objective as possible, if I had to lay odds I’d say that there is a 95% chance that we’d stay past 5 years, and 75% that we’d stay for 15+.

What’s the interest rate savings if I go with an ARM?
Here you’d have to look at current rate curves. At one unlikely extreme, if you’re getting the same rate for both types of loans, of course you’d go for the fixed. Right now, the spread is about 0.5% between a 5/1 ARM and a 30-year fixed mortgage, which is pretty narrow. In the past the spread has been as little as 0.1% and as high as 1-1.2%, possibly more.

Although many mortgages brokers will tell you “even if you end up staying longer than 5 years, you can always refinance”, that’s just not true. You can’t always refinance – check out all those sub-prime borrowers who can no longer get a loan anywhere. They are stuck with rates resetting in the 15% range!

And even if you can refinance, it might be ugly… What if your credit score drops in that time? What if lending standards continue to tighten? What if rates rise significantly? What if your home value drops and your loan-to-value (LTV) ratio is now horrible?

I think ARMs can be a smart buy if you can assess your situation accurately. Some people know they’ll be gone in four years or less. Who knows, rates might actually drop like we’ve seen recently. But no matter what there is an element of risk involved. With rates still at historical lows, we see the downside being a lot worse than any potential upside.

Do I want to rent it out?
This is one consideration I don’t always see mentioned. If I do end up moving, there is a very good chance that I’d like to make my home a rental property. With a fixed mortgage, again I have stability. Rents will rise with inflation, but my mortgage payment will always stay the same. I also don’t have to worry about obtaining a investment-property mortgage, as primary-home loans are usually much cheaper.

In the end, all the signs pointed towards a fixed-rate mortgage for our situation, so that’s what we’re getting. 🙂