Analysis on a 7-year ARM mortgage versus 30-year fixed mortgage

usctrojancpa

usctrojancpa

Well-known member
A few of my clients have seriously considered or opted for a 7-year ARM mortgage versus the 30-year fixed.  I think everyone knows how a 30-year mortgage works, so I'll outline some of the basic points of the 7-year ARM below:

- Interest fixed for 7 years then adjusts annually
- It is a fully amortizing loan (not interest only, not an option ARM, or some other toxic loan)
- There's no prepayment penalty
- Interest rate will be lower than a 30-year fixed mortgage
- After 7 years the interest rate adjusts once a year based upon 1-year LIBOR + 2.25% (1-year LIBOR is currently 0.78%)
- Interest rate can only go up or down a maximum of 2% per year except for the first year where it can adjust 5%
- Maximum interest rate is 5% above the start rate
- Loan balance at the end of year 7 with a 7-year ARM will be lower than with a 30-year fixed mortgage
- Using worst case scenario of the max rate (start rate + 5%) the breakeven point will be early in year 11

I have attached a calculation that I prepared for a few of my buyers to show that assuming the worst case scenario, the breakeven point between the two loans happens between year 11 and year 12.  This is a great loan product for people who are good with their money, plan on accelerating their loan payoff, and/or believe they will sell their home in less than 12 years (on average people sell their homes after about 6-7 years).  My buyers have taken advantage of my commission rebate to buy down the interest rate down to 3.50% and lower.  Note that the interest rate margin between the two loans for a jumbo conforming loan (417,001 to 729,750) is lower and you will have to put at least 75% down to be able to get the loan (only 20% needs to be put down if the loan amount if $417,000 or less). 
 

Attachments

  • 7 year ARM calculation.xlsx
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USCTrojanCPA said:
- Interest rate can only go up or down a maximum of 2% per year
- Maximum interest rate is 5% above the start rate
Click to expand...

if i'm not mistaken, most 7/1 arms have caps of 5/2/5... where the first 5 is the max move in year 8? 
 
villagepeople said:
USCTrojanCPA said:
- Interest rate can only go up or down a maximum of 2% per year
- Maximum interest rate is 5% above the start rate
Click to expand...

if i'm not mistaken, most 7/1 arms have caps of 5/2/5... where the first 5 is the max move in year 8? 
Click to expand...
The majority of lenders have a 2/2/5 cap set-up.
 
Trojan,
Do you know much about the 10 year ARM? What are the rates compared to the 30 year fixed? I am considering the 10 year ARM over the 30 year fixed so that i don't have to put down more than 20%, which I may have to if the bank doesn't give me the full $10k rental income credit.

With one point, my target is for a 4.5% 30 year fixed for a loan amount of $390k closing in June 30th, 2011.

Any advice would be appreciated.
 
Panda paging Trojan and SoyisGreenPeople :D

On a 4.5% 30 year fixed for a $390,000 loan my monthly payment would be $1976.07. By June, 2021 my mortgage balance would be $310,736.25.

If i plan to pay off the entire mortgage in year 10, how much better off would i be with a 10 year ARM?

1) how much interest would i save in the 10 year period between a 30 year fixed or a 10 year ARM?
2) if i continued to pay $1976 a month for the 10 year period what would be my loan payoff balance as of June 2021 for a 10 year ARM?
3) If i am told that i will need to put down more than 20% to qualify for the 30 fixed mortgage.. would i better off taking the 10 year ARM for the full $390,000 loan?

I will get a final answer of how much of a loan i can get from the mortgage broker on monday. The number will come out anywhere from $375,000 to $390,000.

If i can't get the full 80% of my purchase value.. I am seriously thinking about going with the 10 year ARM.
 
Panda said:
Trojan,
Do you know much about the 10 year ARM? What are the rates compared to the 30 year fixed? I am considering the 10 year ARM over the 30 year fixed so that i don't have to put down more than 20%, which I may have to if the bank doesn't give me the full $10k rental income credit.

With one point, my target is for a 4.5% 30 year fixed for a loan amount of $390k closing in June 30th, 2011.

Any advice would be appreciated.
Click to expand...
From what some of my buyers told me, the interest rate difference between a 10-year ARM and 30-year fixed rate isn't very big.  You can see that with a 7-year ARM if you run the worst case scenario you'll be better off with it all the way past the 11th year.  One of my buyers got a 7-year ARM and bought the interest rate down to 3.25% but will be making payments on it as if it was a 4.75% 30-year fixed interest rate.  Making additional payments will reduce the loan balance faster and push out the breakeven point that much further.  His goal is to have the home paid off by year 10.
 
Panda said:
Panda paging Trojan and SoyisGreenPeople :D

On a 4.5% 30 year fixed for a $390,000 loan my monthly payment would be $1976.07. By June, 2021 my mortgage balance would be $310,736.25.

If i plan to pay off the entire mortgage in year 10, how much better off would i be with a 10 year ARM?

1) how much interest would i save in the 10 year period between a 30 year fixed or a 10 year ARM?
2) if i continued to pay $1976 a month for the 10 year period what would be my loan payoff balance as of June 2021 for a 10 year ARM?
3) If i am told that i will need to put down more than 20% to qualify for the 30 fixed mortgage.. would i better off taking the 10 year ARM for the full $390,000 loan?

I will get a final answer of how much of a loan i can get from the mortgage broker on monday. The number will come out anywhere from $375,000 to $390,000.

If i can't get the full 80% of my purchase value.. I am seriously thinking about going with the 10 year ARM.
Click to expand...
Use my spreadsheet to make the calculations.  If your plan is to pay the home off in 10 year, the 7-year ARM might be the better option to go with versus the 10-year ARM as you won't reach your max rate until year 10 with the 7-year ARM.  I use the mortgage calculator on bankrate.com to figure our the loan balances -----> http://www.bankrate.com/calculators/mortgages/mortgage-calculator.aspx
 
Trojan.. thanks for the spreadsheet. So in my case I would be saving $23,416.52 by end of year 7 by going with a 7 year ARM.

My 30 year monthly payment : $1976.07
7 - year ARM monthly payment: $1697.30

You mentioned your buyer is paying down the principal? Wouldn't it be better for you to just keep the savings in a money market account than to pay down the mortgage? I feel like the extra you pay to pay down the mortgage is dead equity where as you can put the savings to work and make some interest. I think it is smart to remove as much equity out of the home as possible and arbitrage your savings.

Trojan, how can I see the amortization schedule on bankrate for at 7 year ARM?
 
Panda said:
Trojan.. thanks for the spreadsheet. So in my case I would be saving $23,416.52 by end of year 7 by going with a 7 year ARM.

My 30 year monthly payment : $1976.07
7 - year ARM monthly payment: $1697.30

You mentioned your buyer is paying down the principal? Wouldn't it be better for you to just keep the savings in a money market account than to pay down the mortgage? I feel like the extra you pay to pay down the mortgage is dead equity where as you can put the savings to work and make some interest. I think it is smart to remove as much equity out of the home as possible and arbitrage your savings.
Click to expand...
Panda said:
Trojan.. thanks for the spreadsheet. So in my case I would be saving $23,416.52 by end of year 7 by going with a 7 year ARM.

My 30 year monthly payment : $1976.07
7 - year ARM monthly payment: $1697.30

You mentioned your buyer is paying down the principal? Wouldn't it be better for you to just keep the savings in a money market account than to pay down the mortgage? I feel like the extra you pay to pay down the mortgage is dead equity where as you can put the savings to work and make some interest. I think it is smart to remove as much equity out of the home as possible and arbitrage your savings.
Click to expand...
He is more risk averse than you or I.  I would put that additional savings to work in some investment vehicle to earn more than the 3.25-3.50% interest rate on the 7-year ARM.  Then when the adjustment period comes up, a determination can be made either it's worth doing a lump sum paydown of the loan or continue investing it.  I mean, there is a chance that the interest rate might adjust the max 2% in the 8th year. 
 
Panda said:
Trojan.. thanks for the spreadsheet. So in my case I would be saving $23,416.52 by end of year 7 by going with a 7 year ARM.

My 30 year monthly payment : $1976.07
7 - year ARM monthly payment: $1697.30

You mentioned your buyer is paying down the principal? Wouldn't it be better for you to just keep the savings in a money market account than to pay down the mortgage? I feel like the extra you pay to pay down the mortgage is dead equity where as you can put the savings to work and make some interest. I think it is smart to remove as much equity out of the home as possible and arbitrage your savings.

Trojan, how can I see the amortization schedule on bankrate for at 7 year ARM?
Click to expand...
You have to keep adjusting it.  At the end of year 7, you put in the new interest rate and the loan balance at the end of year 7 with your term is 23 years....at the end of year 8, you put in the new interest rate the loan balance at the end of year 7 with your term is 22 years and so on.  Also remember that the interest rate buy down is fully tax deductible in the year that you pay it (it'll appear on the 1098 from the lender).

Also, deleted some of your messages on your voicemail because it's full... :p
 
Villagepeople and Trojan,

Tell me if this is correct.

Assuming my 10 year ARM gives me the same rate as 7 year ARM at 3.25%. After 10 years, I would have saved $33,452.17. My balance will be $298,358.10, whereas my balance for the 30 year fixed would be $311,544.03 at 4.5% with one point.

After year 10, I would have saved $33,452.17 (mortgage payments for 10 years) + $13,185.93 (payoff difference) = $46,638.10.

Option 1: I think the worst case scenario for me is that the bank will require me to put down 30% with $144,000 down and finance 30% year fixed at $336000, since my income needs to cover my current townhome mortgage and new home in Atlanta.

Option 2: I can finance the entire 80% ($390,000) with 3.25% 10 year ARM with one point.

Is option #2 a no brainer here? I would be saving $46,638.10 without even including putting this proceeds collecting interest in a money market. If mortgage rates are at 10% come June 2021... I can pay the entire $298,358, which I am capable of doing today. Since this home will be my primary house, and not an investment and have no plans to move for atleast 10 years... I plan not to have a mortgage on this house in 10 years.

For option #1, I would have to pay down an additional $48,000 if my income ratio does not qualify me for $390k 30 year fixed. This all depends on how much the bank will credit me for the $10,000 positive cash flow on my rental property in 2010.

Panda?s Carrying cost calculations on option 1 and 2:

Option #1
$1976 ? 30 year fixed at 4.5%
$320 ? property tax monthly
$166 ? HOA
$50 ? insurance
$2512 monthly carrying cost

Option #2
$1697 ? 10 year ARM at 3.25%
$320 ? property tax monthly
$166 ? HOA
$50 ? insurance
$2233 monthly carrying cost

Difference $279/month,  $3348/year, $33,480 in 10 years.





Panda said:
Trojan.. thanks for the spreadsheet. So in my case I would be saving $23,416.52 by end of year 7 by going with a 7 year ARM.

My 30 year monthly payment : $1976.07
7 - year ARM monthly payment: $1697.30

You mentioned your buyer is paying down the principal? Wouldn't it be better for you to just keep the savings in a money market account than to pay down the mortgage? I feel like the extra you pay to pay down the mortgage is dead equity where as you can put the savings to work and make some interest. I think it is smart to remove as much equity out of the home as possible and arbitrage your savings.

Trojan, how can I see the amortization schedule on bankrate for at 7 year ARM?
Click to expand...
 
Panda said:
Is option #2 a no brainer here?
Click to expand...

i didn't run your numbers but i'll assume they are right, one thing you are not considering is the higher int rate on the fixed also means more tax deduction, so the spread between the two would not be as great, although that still wouldn't shift the scale to the "fixed" side... the other thing is "if" you can get a 10/1 for that low, comparable to a 7/1 then go with the 10/1, but a quick check of bankrate shows 10/1's are going for 4.25 no points and there's a 7/1 for 3%...  if you are going to buy down the 10/1 then you'll need to include that...

one more idea to throw out there, not saying this is better but, if you have the cash and it's just going to sit there in the bank... instead of paying the minimum for 10 years then a balloon payment, calculate it out so that you pay enough extra every month so that the loan balance will be paid off during the fixed period, in 10 years.... if i'm not mistaken you'll pay less in interest. 

and finally, although you have the ability to pay off the whole loan once year 11 comes along... remember to ask about the index+margin, initial adjustment cap, additional adjustment caps, and lifetime cap.
 
Standard Conforming ARM loans are 5/2/5's. If it's anything other than that it's likely not a FNMA/FHLMC product.

To avoid "analysis paralysis" between which loan is better, the key issue to focus on is discipline. Are you disciplined enough to make every single payment as indicated, or might for personal reasons could you stray off the reservation and not follow through on your mortgage prepayment plan? In that scenario, the rate and cap difference is inconsequential, but the length of lock is very important. 

I sell 5/1 ARMs as a 6 - 7 year break even, a 7/1 as an 8 - 9 year break even, and the 10/1 (when they were competitive...) as a 12-13 year break even loan. What the cap is in 5, 7 or 10 years is a bit meaningless also since the adjustment is based not just on the rate, but also on the balance. If you can get a 4.0% rate for 7 years with a higher cap (5/2/5) that may be better than an ARM starting at 4.25% with a 2/5/2 cap. Sounds like I'm heading down the analysis paralysis trap already!

If you're also putting minimum down, the FHA 3/1 ARM is a spectacular loan. Rates run in the low 3's with 1 annual, 5 life caps. Yes, there is a terrific risk in looking at a 3/1 ARM relative to a 30 fixed, but all options should be put on the table for review, not just the easy ones.

My .02c

Soylent Green Is People.
 
villagepeople said:
Panda said:
Is option #2 a no brainer here?
Click to expand...

i didn't run your numbers but i'll assume they are right, one thing you are not considering is the highe int rate on the fixed also means more tax deduction, so the spread between the two would not be as great, although that still wouldn't shift the scale to the "fixed" side... the other thing is "if" you can get a 10/1 for that low, comparable to a 7/1 then go with the 10/1, but a quick check of bankrate shows 10/1's are going for 4.25 no points and there's a 7/1 for 3%...  if you are going to buy down the 10/1 then you'll need to include that...

one more idea to throw out there, not saying this is better but, if you have the cash and it's just going to sit there in the bank... instead of paying the minimum for 10 years then a balloon payment, calculate it out so that you pay enough extra every month so that the loan balance will be paid off during the fixed period, in 10 years.... if i'm not mistaken you'll pay less in interest. 

and finally, although you have the ability to pay off the whole loan once year 11 comes along... remember to ask about the index+margin, initial adjustment cap, additional adjustment caps, and lifetime cap.
Click to expand...

Thanks Villagepeople, can i ask where in bankrate you are able to see the 7ARM and 10ARM rate?

Thanks.
 
Panda said:
Thanks Villagepeople, can i ask where in bankrate you are able to see the 7ARM and 10ARM rate?
Click to expand...

this link is for irvine... http://www.bankrate.com/funnel/mortgages/mortgage-results.aspx?loan=390000&prods=10,9&market=973&perc=20&points=Zero&fico=700|719

or you can just go to bankrate.com and look for "Find a Mortgage rate:" upper left... and start from there.

vp
 
sgip said:
Standard Conforming ARM loans are 5/2/5's. If it's anything other than that it's likely not a FNMA/FHLMC product.

To avoid "analysis paralysis" between which loan is better, the key issue to focus on is discipline. Are you disciplined enough to make every single payment as indicated, or might for personal reasons could you stray off the reservation and not follow through on your mortgage prepayment plan? In that scenario, the rate and cap difference is inconsequential, but the length of lock is very important. 

I sell 5/1 ARMs as a 6 - 7 year break even, a 7/1 as an 8 - 9 year break even, and the 10/1 (when they were competitive...) as a 12-13 year break even loan. What the cap is in 5, 7 or 10 years is a bit meaningless also since the adjustment is based not just on the rate, but also on the balance. If you can get a 4.0% rate for 7 years with a higher cap (5/2/5) that may be better than an ARM starting at 4.25% with a 2/5/2 cap. Sounds like I'm heading down the analysis paralysis trap already!

If you're also putting minimum down, the FHA 3/1 ARM is a spectacular loan. Rates run in the low 3's with 1 annual, 5 life caps. Yes, there is a terrific risk in looking at a 3/1 ARM relative to a 30 fixed, but all options should be put on the table for review, not just the easy ones.

My .02c

Soylent Green Is People.
Click to expand...

SGIP, it is good to see that you are still around. I guess my priority is that i don't want to put more than 20% down on my home. If the bank qualifies me a for a $375,000 30 year fixed loan based on my income, I rather get the 10/1 ARM if I can qualify for the full 80% value of my purchase price.

Here are bank rate is showing me today for 0 poiints

30 year fixed - 4.86%
10/1 ARM - 4.42%
7/1 ARM - 4.10%

If i pay a point, what are rates i can get today? SGIP, do you foresee any major votality in the rates from now until June where i need to lock 60 days in advance? or do you think the mortgage rates should be stable in the next three months?
If I can potentially lock 4.00% - 4.25% on a 10/1 ARM between now and June for a loan of $390,000? I think I would be very happy.





Thanks.
 
VP -

Take two loans. A $400,000 7/1 ARM at 4.0% in 7 years has a balance of $339,626 assuming no prepayments made. Loan A has a 2/5/2 cap.  The new payment assumes that balance x 23 years. If the 4.0% goes to 6.0% the payment is $2,271

Loan B has a rate of 3.75%. The balance in 7 years is $337,497. If the rate is 7.0% the payment is 2,463.00, $192 more per month - assuming rates are higher in 2018

During those 7 years however you paid almost $7,000 more in interest compared to the lower rate cap mortgage. That's a very high price to pay relatively speaking. What if you put that $7k difference into your balance over the 7 years gone by? Your balance then is $330,497. At a 7.0% rate the payment is $2,412.

Remember, the difference between a 5% first adjustment and a 2% first adjustment is only good for 1-2 years at best. After then both loans are at the same payment position.

Some borrowers believe that the new adjusted payment in year 7 is based on the original balance. That is not the case.


Panda -

I've been unavailable over the past 3 days due to a terrific chest cold. It's on it's final legs thanks to the AWESOME POWER OF NYQUILL. That juice is a real slate wiper.

Here's your problem. Once the Fed ends QE-2, no one (let me translate for the hard of hearing.... NO ONE) knows where rates will go. When the Fed is soaking up 70% of all new Federal debt, someones got to fill the void after The Bernank lifts off and flies elsewhere. I'd talk to your lender now about an extended rate lock. Yes, it's expensive, but it's relatively cheap insurance if rates go sideways. Let's say rates do go up, will you continue with your purchase, cancel, then wait for the builder to reduce prices? That's a worse case scenario, but something to consider.

BankRates data is unreliable at best. It does not take into account a great number of things that can influence rates. For example, anyone locking in an FHA loan after 4/18/2011 will be subject to higher MMI. BankRate does not reflect this for months later. With LO Compensation likely changing once the Courts get through with it by Wednesday, costs and rate will change by quite a bit. Since brokers (the source for most of BR's information) will have to keep compensation limits near equal to what banks charge, the average rates BR shows will be impacted as well, but not for several weeks. Yes, BR can give you a snapshot, but it's akin to gazing into a dark mirror trying to figure out what you look like.

My .02c
 
The spreads between 30 fixed loans and ARM products has widened in the past few weeks. It used to be about .25 to .50 but now is upwards of .75 in rate between fixed and ARM's.  My guess is that lenders don't want long term 30 fixed on their books if rates rise.

The rate buydown costs for 30 fixed loans are also becoming really expensive (4.750% / -0- points vs 4.625% / 2.5 points for example).

My .02c

Soylent Green Is People.
 
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