Will a 7/1 ARM be better vs a 30yr fix rate for a mortgage if I am prepaying part of the principal every year

Question

I am a 1st time home buyer and I have just accepted a counter offer from a seller for a house that I like. The next step was to apply and get a mortgage for buying this house. Some background on the house and type of loans that I was offered by a lender:

• loan amt: ~200k

• down payment: 15%

• closing cost and any other fees paid in cash and not included in the loan amount.

loan choices:

1. 7/1 ARM @ 3.5% with 5%/2%/5% for initial/periodic/lifetime rate caps monthly payment ~929 (excl pmi, insurance, taxes, utilities, ...) monthly prepayment 1.1k
2. 4.75@30 yrs monthly payment ~1079 (excl pmi, insurance, taxes, utilities, ...) monthly prepayment 1k

I do not plan to stay in this house for more than 6-8 yrs (hopefully). Also, I am willing to prepay the loan by 1k every month, so eventually the interest that I pay out is very less.

My question is that, under these circumstances, is the 7/1 ARM a better option than the 30yr fixed?

If I do go with the 7/1, and due to different circumstances, I continue to stay in the same house, I would plan to refinance it as a 10yr fix, since by that time I would have paid more principal with the 7/1 than with the 30yr fixed.

Does this strategy make any financial sense?

Update: Thanks for all the suggestions and comments. The cautious me eventually won over the riskier me and I went along with the 30yr fixed. Also, another reason was that I got even better rate now that we have the upheaval about the downgrade going on.

Answer 1

The big problem with ARM's is they can turn into traps. If interest rates have gone up significantly in 7 years time, and especially if you are pushing things to the limit JUST to pay the mortgage, then you can find yourself stuck in a situation where you can't afford to refinance (because the rates are higher) and can't afford to pay the rising costs in an arm. So you might be forced into selling into a unfavorable market instead of having the option to hold and let the market recover.

Another nightmare scenario is if housing prices have fallen, and you can't refinance because the property is under-water and nobody will write a loan for more than the house is worth. You'd then be stuck paying higher payments on a property that is worth less. (just set the wayback machine to say 2005 and imagine if you'd made a similar investment to what you are considering, with a plan to plan to sell in 6 years.)

In your case it seems you have ample cash flow to sustain an increase in the payments. So unless your income changes in that time, 'making the new payments' may not be a big risk for you. However being faced with higher interest rates than you'd have on a fixed may still be an issue. As could be the property being under-water value wise.

OTOH if you can afford to pay a larger amount, and plan to do so every month, you might want to just look at a shorter term fixed rate loan, which will have a lower interest rate than a standard 30 year loan would. Because it doesn't take that much of an increase in principle payments to drastically shorten a loan, the payments on a 15 year loan may be lower than you'd expect. (many folks just assume, due to bad math, that it will be twice as large a payment as a 30 year loan)

Personally, if you DO decide to go with the ARM, I'd suggest you strongly consider what your REAL cost (interest minus your tax deduction) of the money is, and if it would make more sense to be investing that extra each month somewhere else rather than only earning the effected few percent you'd get by prepaying on the loan. Even with something fairly conservative like ladder of 5 year CD's or a Ginny=mae fund, you might be able to earn more than you'd be saving in interest.

With a fixed rate loan you know what your payments will look like in the future. With an ARM you trade a lower rate now, for the risk of a substantially higher rate later.

Answer 2

I think your strategy makes alot of sense. The key is that you have the funds available to cover the mortgage in the event the rate escalates. So you're trying to optimize your costs, not figure out how to make your mortgage payment!

IMO, you should try to figure out:

• The interest you'll save in years 1-7
• The maximum additional interest that you'll have to pay in years 7-10, 7-12, etc, assuming worst case scenario for the ARM rate escalation. (run a few scenarios)
• The worst-case scenario for holding the loan until paid. (Assume you cannot get another mortgage at the 10-year mark, or that rates rise faster than your maximum ARM adjustment)

Once you have these numbers, it should be pretty easy for you to build a few financial models based on what you feel is more or less likely to happen.

Answer 3

I know you like the house, I personally am scared, but your reasoning and thoughts make sense. I am not trying to be bossy, but throw one more scenario into your comparisons for funds over the next 6-8 years.

Rent a house. Rent a nice house comparable to what you are looking to buy. It will cost more than some crappy apartment, but can you get a lease from an accidental landlord that will save you money?

I only bring it up since you are already planning on not being in the house. How positive are you that you will sell it for enough come 6-8 years from now?

Just something to think about. You might have already considered and discarded the idea.

Answer 4

Your analysis is really good. There are a couple of other things to consider, especially risk. What happens if:

• You lose your job or other income? Would you be able to make your extra payment?
• What if your living conditions change? Marriage, divorce, kids? Would that affect your ability to make your payment?
• What if you move because of a job?
• Where do you think interest rates will be in 7 years? What are the chances that they will be much higher than now?

If your answers support the rest of your analysis, then 7/1 ARM might be right for you.

I guess my point is that 7 years is a long time, and we really don't know where we will be or what the economy will be like. So it is important to think about what could change.

The 30 year fixed is the "safe" option. But it will be much more expensive if you have it less than perhaps 10 or 12 years.

Another thing to consider is the possibility of getting an assumable mortgage. That means that it is possible for the person you sell the house to qualify and take over your existing loan. In that case, a 30 year fixed could be a better choice, especially if you think that interest rates are going to go up.