finance dudes, help me with a mortgage question

R

raiden031

Legend
I am working with a lender so I can buy a home (first time buyer). I don't have money for a down payment, so I am going the 80/20 route. Anyways I was given two options for the 80% loan:

Option 1: 30 year fixed at 6.75%
Option 2: Interest-only 5/1 ARM at 7.25%

(I don't understand why Option 2 is a higher interest rate)

The lender told me option #2 was better (assuming I understand the consequences when 5 years hits) but I crunched numbers and couldn't figure out why it is better. I am a computer programming guru, so I created a program that uses the amortization formula to show me my principle and interest payments over the life of the loan.

After 5 years (end of IO term), here's what I found, while ignoring appreciation.

Option 1: I have $13,500 in equity towards the house. No cash in the bank.

Option 2: I saved $100/month in monthly payments which is $6000 in cash in the bank over 5 years. Although I paid $8000 more interest than option 1 (bigger tax break).

So I am worth more (over double) with option 1 than I am with option 2. In order to turn my $6000 cash into $13,500, I'd have to earn an unrealistic annual return on that money. Not likely to happen.

Why/how is option 2 a better deal? All that so I can save only $100/month.
 
Looks like you answered your own question.

Did you look into the FHA first time homebuyers program? That's what I used. You only have to put 3% down.
 
boxingguy said:
Looks like you answered your own question.

Did you look into the FHA first time homebuyers program? That's what I used. You only have to put 3% down.
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I can't really afford to put anything down. Those programs don't seem to help me because I have good enough credit and income to get 100% financing with a better rate getting a regular loan without anything down. When I say I can't afford to, I mean that if I got laid off from my job, I need money in the bank for expenses. Putting a down payment plus the high price of closing costs is just not feasible and I'd be in default if anything unexpected happened.

I realize I answered my question, but I just wanted to make sure there isn't something I'm missing since I am far from an expert in finance. I don't understand why my lender would recommend a loan that doesn't really show itself to be better. If the IO interest rate was lower, it might make sense to me.
 
Sounds like you've already done your homework, but here's excerpts from a couple of magazine articles just in case:

Consumer Reports, Aug2005:
"These days, it can be easy to get a mortgage even for a home that seems financially out of reach. . .But this is not such a good thing.
Many loans that mortgage brokers and lenders are pushing increase the odds of foreclosure by allowing borrowers to accept more risk than they can manage, especially if home prices level off or if interest rates increase. That’s because some loans, such as interest-only mortgages, keep monthly payments artificially low at first but can skyrocket to unaffordable levels later on. . . Here are some of the riskiest mortgages, and why we don’t recommend them:
Interest-only mortgages. After 3, 5, or 10 years of paying only interest on your loan, monthly payments can jump 25 percent when principal is added to the bill. Because most of these mortgages have adjustable rates, you could get hit with a double whammy. If after 5 years the rate on your $200,000, 53⁄8 percent mortgage rises by 5 percentage points, for example, your payments, including principal, could double, from $896 to $1,871. With rates rising, it may be hard to find a cheaper loan or to sell. Because you haven’t paid down equity, you can end up owing the bank more than your home is worth if housing prices fall. . ."

Time, 3/6/2006:
"YOUR BEST INTEREST? Taking out an interest-only loan means that at least initially, all you're paying back is interest; you're not making a dent in the principal until after the interest-only introductory period, typically five or 10 years down the road. So if you bought a $300,000 home, put down 10% and signed a 5.75% interest-only adjustable-rate mortgage, you could expect monthly payments of $1,294. But interest rates are low now. If after five years they inch back up to a more normal 8.75%, you would find yourself staring at a $2,200 monthly mortgage payment. Whose bright idea was that?"

raiden031 said:
I can't really afford to put anything down. Those programs don't seem to help me because I have good enough credit and income to get 100% financing with a better rate getting a regular loan without anything down. When I say I can't afford to, I mean that if I got laid off from my job, I need money in the bank for expenses. Putting a down payment plus the high price of closing costs is just not feasible and I'd be in default if anything unexpected happened.
I realize I answered my question, but I just wanted to make sure there isn't something I'm missing since I am far from an expert in finance. . .
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I am also far from "an expert in finance", I'm just a consumer who has been through the the process. I used an FHA first time homebuyers loan, putting down 3% on a fixed rate 30 yr. After 7 years, I refinanced to a 15 yr fixed at a lower interest rate. I am very happy with my choices.

Why do you have to buy a house now? Housing prices seem to be flattening out now. What's wrong with saving up for a down payment? In the meantime you can also take active steps to firm up your employment status ("I mean that if I got laid off from my job"). It sounds like that's a concern at the moment. Do you really want to go hundreds of thousands of dollars into debt in your current situation?

raiden031 said:
I don't understand why my lender would recommend a loan that doesn't really show itself to be better. . .
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It sounds like you already know the answer to this question, but you're too nice of a person to say it out loud. Again, I am also far from an expert, I just know from my experience and what I read from materials like the articles above.
 
Somebody correct me if i'm wrong, but i think the lender gets a larger commission on some of the more exotic types of mortgages. I read an article on Option ARM mortgages, and it seems like some lenders misguide people into getting these things so that they can get a larger piece of the pie.

But then again, I don't really know what i'm talking about.
 
I wouldn't get an adjustable rate mortgage now. Interest rates are likely going up? Most ARM rates are lower also, not higher. When I bought my first house, my interest rate was 15.5%, and I thought that was good, since many others were paying 18%. Take the lower rate.

For the first year, your broker is telling you that the difference in interest rate, a half percent, can be made up by the difference in downpayment. Instead of putting that money into a downpayment, you could invest it, and easily earn more than the 1/2 percent. After 2 years, you can refinance at the current interest rate, and would have made money on the "downpayment" you didn't have to make.
 
raiden031 said:
Option 1: 30 year fixed at 6.75%
Option 2: Interest-only 5/1 ARM at 7.25%
(I don't understand why Option 2 is a higher interest rate)
Click to expand...

I is higher in Option 2 b/c it is a higher risk loan from the lender's point of view.

raiden031 said:
Why/how is option 2 a better deal? All that so I can save only $100/month.
Click to expand...

Typically, a loan officer will say and do what's best for the lender. He/she's trying to get the best deal for the bank and NOT the borrower. A loan agent is worse since he/she wants to sell you on a loan that will pay the largest amount of commission which goes in their pockets. You're probably being told that Option 2 is a "better" option b/c the payments are $100 less/mo.

I'd take the fixed interest rate, if I were you. In the event that the I goes down within the next few years, you can always re-fi.
 
whodey said:
Somebody correct me if i'm wrong, but i think the lender gets a larger commission on some of the more exotic types of mortgages. I read an article on Option ARM mortgages, and it seems like some lenders misguide people into getting these things so that they can get a larger piece of the pie.

But then again, I don't really know what i'm talking about.
Click to expand...

The lender is the one directly lending the money to a borrower. Why would they be getting a commission? And more importantly, from where would this commission come?
 
Terminilogy is the issue here.
There are 2 sides of the industry: Retail and Wholesale. Most lenders have both sides, some only have one side. When you say Lenders you need to be specific as to which side that you are dealing with as each side operates differently and pays differently.
The wholesale side deals with mortgage brokers who operate as a middle man between you and the lender and pays the broker a premium for bringing them the business and selling you a certain rate. Brokers can be signed up with 100+ different wholesale lenders and have access to thousands of programs for the customer, at which they get paid on the rate that they sell to you plus any origination points that they charge you. The loan officer gets paid off of the difference in rate passed onto you and and any origination points charged to you.
The retail side deals with the customers directly and only have thier set of loan programs that they can fit you in. Retail lenders typically give you a bottom rate with no points and let you have the choice of paying discount points to lower the interest rate for the fixed portion of the term that you are choosing. The loan officer in the retail side usually gets paid a salary plus a bonus based on volume and number of units, not the overcharging of a rate to you.
Is option one better for you than option 2? Answer these question.
...how long you plan on being in the home? the longer you plan on being in the home the more important a long term fixed rate will be to you. No one knows what rates are going to do.
...what is the appreciation rate been like over the past 2 years in that area? you do not want to be in an adjustable rate loan and be in a declining value market. You will end up being stuck and not being able to refi without bringing money to the table to close.
...will the tax savings of the higher rate help you now on a monthly payment? will the 100 in savings per month really make that big of a difference in your monthly budget? keep in mind you are trading a cheaper payment now for no principle balance reduction.
...future unexpected issues and loan stability. Loan stability will always win out in your case. You are concerned about your "nest egg" needing to be used if something happens. Plan for the worst and hope for the best. If your rate increases and things are not in the best case scenerio, you could be forced with a higher payment=less money=digging into the nest egg....

Long term rates are no brainers: less stress and you always know what your payment will be on the principle and interest portion of your loan.

Have more questions...fire away. I am a whole lot better at the mortgage stuff than I am at the tennis stuff.
 
I would not go with an ARM over a fixed rate mortgage, especially in today's relatively low interest rate environment. In fact, if you were able to afford it, I would go with a 15-year fixed rate mortgage over a 30-year mortgage since you will end up paying much, much less in interest overall.

It also depends on how long you expect to stay in that house. If it's more than 10-15 years, then it probably doesn't make a whole lot of sense to go with an ARM as not only can the interest rate go up significantly, but with an interest-only loan, you will make no dent in your principle so you will end up still owing the bank your entire loan amount even after 5 or 15 years of payments (depending on how you refinance after your 1st 5 year term).

The interest-only ARM probably has a higher interest rate because there's more risk for the lender. Since you're not paying off any of the principle, you're not really building up any equity (assuming zero appreciation) so it would be easier for you to "walk-away" from the loan if housing values collapse. An interest-only mortgage is essentially like renting (again, assuming no appreciation in the value of your home), except that you get to write off the interest payments on your taxes, but your pre-tax monthly payments are probably higher than what your rent would be on a comparable residence, so it also depends on what tax bracket you're in to determine if you're financially better off buying or renting.

Anyway, I'm more in favor of conventional fixed-rate mortgages (especially shorter ones) since there are fewer potential future surprises and that gives you more peace of mind to sleep better at night in your new home. :D

Good luck with whatever you decide.
 
boxingguy said:
I am also far from "an expert in finance", I'm just a consumer who has been through the the process. I used an FHA first time homebuyers loan, putting down 3% on a fixed rate 30 yr. After 7 years, I refinanced to a 15 yr fixed at a lower interest rate. I am very happy with my choices.

Why do you have to buy a house now? Housing prices seem to be flattening out now. What's wrong with saving up for a down payment? In the meantime you can also take active steps to firm up your employment status ("I mean that if I got laid off from my job"). It sounds like that's a concern at the moment. Do you really want to go hundreds of thousands of dollars into debt in your current situation?



It sounds like you already know the answer to this question, but you're too nice of a person to say it out loud. Again, I am also far from an expert, I just know from my experience and what I read from materials like the articles above.
Click to expand...

The reason I want to buy now is because I want to move into a single family home and will never be able to save up a downpayment. The average single family home in my area is between 400-500K. That means I need to save up 80-100K in order to pay the required 20% down. It would take me YEARS to save that much money, and by the time I have that much money, the houses will probably cost 800K, so I'd need 160K. If I buy something smaller now, I can build my downpayment faster through home appreciation, but I may get ***** in the process by the 80/20 interest rates a little. Plus I am getting ***** by income taxes since I'm renting right now.

The reason I am afraid of being laid off is because it has already happened once since I am a disposable government contractor in the IT industry. There is no such thing as job security in my field unless you work directly for the gov. With that being said, I have the skills and there's enough demand to find a job quickly when it does happen though.

I've already chosen the fixed rate loan, and was told my rate is decent for someone who is financing 100%.
 
BreakPoint said:
I would not go with an ARM over a fixed rate mortgage, especially in today's relatively low interest rate environment. In fact, if you were able to afford it, I would go with a 15-year fixed rate mortgage over a 30-year mortgage since you will end up paying much, much less in interest overall.

It also depends on how long you expect to stay in that house. If it's more than 10-15 years, then it probably doesn't make a whole lot of sense to go with an ARM as not only can the interest rate go up significantly, but with an interest-only loan, you will make no dent in your principle so you will end up still owing the bank your entire loan amount even after 5 or 15 years of payments (depending on how you refinance after your 1st 5 year term).

The interest-only ARM probably has a higher interest rate because there's more risk for the lender. Since you're not paying off any of the principle, you're not really building up any equity (assuming zero appreciation) so it would be easier for you to "walk-away" from the loan if housing values collapse. An interest-only mortgage is essentially like renting (again, assuming no appreciation in the value of your home), except that you get to write off the interest payments on your taxes, but your pre-tax monthly payments are probably higher than what your rent would be on a comparable residence, so it also depends on what tax bracket you're in to determine if you're financially better off buying or renting.

Anyway, I'm more in favor of conventional fixed-rate mortgages (especially shorter ones) since there are fewer potential future surprises and that gives you more peace of mind to sleep better at night in your new home. :D

Good luck with whatever you decide.
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My monthly payment (excluding property taxes, HOA fees, and HO insurance) is going to be 1900 for the 30 year fixed, so 15 years is definitely out of the question for me right now.

The thing about the interest-only ARM rate is that the point of it is to minimize my monthly payment so that I can invest the cash difference into a better investment. But the cash difference is so small, that I end up with less than half the cash than I would equity with the 30 year fixed.

It seems like the only way an interest-only could be beneficial even to a savvy investor is to have a lower interest rate than the 30 yr fixed.
 
Steve Huff said:
I wouldn't get an adjustable rate mortgage now. Interest rates are likely going up? Most ARM rates are lower also, not higher. When I bought my first house, my interest rate was 15.5%, and I thought that was good, since many others were paying 18%.
Click to expand...

Ah, the days of Jimmy Carter. How well I remember. We got our first mortgage at 8% in 1976 and watched in horror as rates rose above 20% in the next few years. Waited it out and bought our next house in 1986 at 10 1/8. Thought we were getting a deal :).
 
psp2 said:
I is higher in Option 2 b/c it is a higher risk loan from the lender's point of view.



Typically, a loan officer will say and do what's best for the lender. He/she's trying to get the best deal for the bank and NOT the borrower. A loan agent is worse since he/she wants to sell you on a loan that will pay the largest amount of commission which goes in their pockets. You're probably being told that Option 2 is a "better" option b/c the payments are $100 less/mo.

I'd take the fixed interest rate, if I were you. In the event that the I goes down within the next few years, you can always re-fi.
Click to expand...

All the research I have done say that an ARM has a better rate than a fixed. But they said that adding an interest-only option to either will raise the rate.

But I thought the IO ARM should still have an equal to or lower rate than a fixed rate in order to make the monthly payment shrink enough that the borrower would choose the IO ARM over the fixed. $100 less doesn't seem like much value when the borrower has an 80/20 loan and the 80% loan itself is 1450/month (down to 1350/month) and the borrower is paying another 450/month for the 20% loan. So instead of paying $1900, you pay $1800 and have no equity when 5 years hits.
 
K. Wilson Moose said:
Ah, the days of Jimmy Carter. How well I remember. We got our first mortgage at 8% in 1976 and watched in horror as rates rose above 20% in the next few years. Waited it out and bought our next house in 1986 at 10 1/8. Thought we were getting a deal :).
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I wouldn't mind paying 20% if single family homes were less than 100K. :grin:
 
the value in the interest only products is the reduction in a payment and the better tax break at the end of the year....you typically cant have your cake and eat it too...HOWEVER interest only rates are all LOWER than the fixed rates that I have....and they should always be...someone isnt taking care of you in the rate department.
 
raiden031 said:
It would take me YEARS to save that much money, and by the time I have that much money, the houses will probably cost 800K, so I'd need 160K. If I buy something smaller now, I can build my downpayment faster through home appreciation, but I may get ***** in the process by the 80/20 interest rates a little.
Click to expand...
I'm sure you realize that that's an assumption and not a guarantee, especially in today's capricious real estate market, right? The value of your house can go down as much as up. I lived through the last major decline in the housing market in the late-80's/early 90's and it was quite ugly. BTW, personally, I believe we're still in a housing bubble in most parts of the country. Anyway, you've already got the loan so no need to worry about it now. :D
 
We are seeing major cooling trends in all the major markets. Areas such at Michigan are in a 5-9% decrease in appreciation over the last 2 years due to car manufacturers and the cooling in their industry also.
Areas like the coasts are seeing a rapid decline in the appreciation and it is now a buyer's market for sure in all areas.
 
psp2 said:
The lender is the one directly lending the money to a borrower. Why would they be getting a commission? And more importantly, from where would this commission come?
Click to expand...

The loan gets a commision from his employer. Commercial loan officers make a killing. That's why one of the reasons loans are so easy to get.
 
Smooothone23 said:
the value in the interest only products is the reduction in a payment and the better tax break at the end of the year....you typically cant have your cake and eat it too...HOWEVER interest only rates are all LOWER than the fixed rates that I have....and they should always be...someone isnt taking care of you in the rate department.
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And all of the examples I have found on the web agree with you. Either the lender/broker/officer that I have been working with made a mistake on the rates or they perceived me as young, inexperienced, and naive and upped the rate with hopes that I would still choose the IO loan because of the monthly payment savings.
 
BreakPoint said:
I'm sure you realize that that's an assumption and not a guarantee, especially in today's capricious real estate market, right? The value of your house can go down as much as up. I lived through the last major decline in the housing market in the late-80's/early 90's and it was quite ugly. BTW, personally, I believe we're still in a housing bubble in most parts of the country. Anyway, you've already got the loan so no need to worry about it now. :D
Click to expand...

I did my own little risk analysis on the matter. Here's my scenario for X number of years down the road.

Choice 1: Continue to rent.

If home values continue to skyrocket, then the amount of additional money I can put away in the bank due to renting will not be nearly enough to bring me within reach of getting a single family home. If home values are stagnant or even decline, then I will have alot of cash in the bank that I could put towards that dream home.

Choice 2: Buy a starter house.

If home values continue to skyrocket, then I will earn alot of equity from the house's appreciation and can use that for a down payment of my dream home. If home values are stagnant or even decline, then I will have gained little or nothing towards buying that dream home, but at least I have a home already and can keep paying it down until the market comes around.

I figure buying a starter house is more likely to put me in position to buy a single family home.
 
When I got my 3 year ARM I locked in at 3.875%. Now the rates are much higher so I plan to pay down more on the loan once the 3 years is up in April.

In your case the ARM is higher than the 30 year. I would go with the 30 year myself since you are guaranteed that rate for 30 years. With our deficit continuing to climb, it's likely interest rates will go higher over the next 30 years.
 
Interest rates will go higher over the next 30 years? Things didn't quite work out like that.

kevhen said:
When I got my 3 year ARM I locked in at 3.875%. Now the rates are much higher so I plan to pay down more on the loan once the 3 years is up in April.

In your case the ARM is higher than the 30 year. I would go with the 30 year myself since you are guaranteed that rate for 30 years. With our deficit continuing to climb, it's likely interest rates will go higher over the next 30 years.
Click to expand...
 
Would I be considered a very weird person if I say I never borrowed money from any financial institution in my whole life?
I believe that with people like me, the US economy would have been bankrupt long ago.
 
The contemporary economy has become ever more dependent on creating debt slaves, but borrowing to buy a productive asset or create a business has always been a part of capitalism.

Sudacafan said:
Would I be considered a very weird person if I say I never borrowed money from any financial institution in my whole life?
I believe that with people like me, the US economy would have been bankrupt long ago.
Click to expand...
 
travlerajm said:
I just closed a 30-year fixed refi at 2.75. Not bad.
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I really, really wish I had enough dough to snap up a 2nd home right now. My roomie and I bought our condo last year at 4.5% - which would've been around 4% if not for this down payment assistance program (including a sweet 2% state grant) for 1st-time homebuyers - and would definitely benefit from the current rock-bottom rates... except that a refi would mean we lose our 20% mortgage credit on interest for the life of our loan so we're more or less stuck. :mad:

Sudacafan said:
Would I be considered a very weird person if I say I never borrowed money from any financial institution in my whole life?
I believe that with people like me, the US economy would have been bankrupt long ago.
Click to expand...

That works if you can pay for everything up front, but I'm guessing you're still renting and don't have/need a car. This bud of mine was in the same boat and naturally got hit with close to a double-digit rate on his new car a couple years back (FYI anywhere from 0-3% would be par for the course for most buyers with good credit here in the US)... and he still hasn't opened another line of credit even though he's now looking to buy a home! I've tried to explain to him that in our market economy it's all but necessary to have some "bad" debts like credit cards so you can get build up your credit and eventually get a good rate on your "good" debts like mortgage/auto/student loans, but he refuses to listen.

And you shouldn't be surprised that he's just as stubborn about not getting a smartphone... while carrying a tablet with him all the time! I mean there's only so much you can do to convince people of their folly. :rolleyes:
 
NonP said:
That works if you can pay for everything up front, but I'm guessing you're still renting and don't have/need a car. This bud of mine was in the same boat and naturally got hit with close to a double-digit rate on his new car a couple years back (FYI anywhere from 0-3% would be par for the course for most buyers with good credit here in the US)... and he still hasn't opened another line of credit even though he's now looking to buy a home! I've tried to explain to him that in our market economy it's all but necessary to have some "bad" debts like credit cards so you can get build up your credit and eventually get a good rate on your "good" debts like mortgage/auto/student loans, but he refuses to listen.

And you shouldn't be surprised that he's just as stubborn about not getting a smartphone... while carrying a tablet with him all the time! I mean there's only so much you can do to convince people of their folly. :rolleyes:
Click to expand...
I don’t rent. I own everything I use.
 
They've invented a form of credit where you basically 'lay-by' the product, but you get it up front without any interest.

The trick is that if you don't keep up with the four equal payments then you do pay interest, and that's a lot of money.
 
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