Mortgage Options

[younginvestor2013]

Well, I am starting off the new year with a bang! I'm under contract to purchase a new condo. I am mortgage shopping and curious to hear the ER community's thoughts. I originally intended to put 20% down and do a 30 year, traditional fixed but a new attractive option has come up.

Assuming a $430k purchase price, what option would you choose below? Note, this is a condo (so interest rates are slightly higher than SFH) in a major US city.

Option 1
30-year traditional fixed at 4.625% with no underwriting fee. 20% down ($86k). Monthly P&I: $1,769

Option 2
10/1 ARM, 3.5% interest rate years 1-10 based on 30-year amortization. 10% down ($43k), no PMI despite the low DP. Beginning in year 11, the rate would change annually with a cap of 8.5%. It won't necessarily go that high, but that is the cap. Monthly P&I years 1-10: $1,738

Option 3
Same as Option 2 above, but put down 20% ($86k) instead of 10%. Monthly P&I years 1-10: $1,545

As you can tell, I am leaning towards option 2. I like this option because I can hold onto an extra $43k by not having to put a full 20% down and my monthly payment is in-line with option 1 due to the lower interest rate.

Obviously, option 2+3 are not favorable if I intend to live in the condo beyond 10 years. My loan officer thinks is unlikely that I will live there for more than 10 years, given my age and that it is a condo in the city which is, by nature, more transient. Putting down 10% or 20% is both possible for me (I have liquid assets to do 20% if necessary), but I like the idea of holding onto an extra $43k and investing that instead of putting it into my home.

Here are some background details:

Age - 29
Assets - $425k split across Roth 401k, Roth IRA, Taxable Investments, and Cash, not including about $40k equity in current home, which is being sold
Income - $100-110k
Other - my SO will be living with me, and we will be splitting the all-in monthly cost, although the condo is being purchased by me and going in my name only. my SO's income is also about $100-$110k.

 

[USGrant1962]

I used 7/1 ARMs a couple of times when younger and they worked out well. Just one caution, that was in a long-term declining interest rate environment. You are more likely facing a long-term rising interest rate environment. So a refi or your next purchase may well be at a higher rate.

But in your shoes I would probably go with #2 or #3. That rate is a huge discount.

 

[pb4uski]

Have you looked at 15 year fixed? It looks like the rate would be a little more than the ARM but with no uncertainty as to your interest rate in 10 years... payments would be more but the extra payment compared to a 30 year or the ARM is all going to building equity and in the long run you will pay much less interest.

 

[RunningBum]

So the ARM is fixed for the first 10 years? I'd go for that. Seems very unlikely you'd stay in a condo for more than 10 years, since your needs might change, maybe you'd want to move to a house, get married, take a job in another city, etc. You'd have to answer the likelihood of that for yourself.

 

[ERD50]

I'd also say option #2 after looking at 15 year fixed as pb4uski suggests.

This probably is a rising rate environment, but 10 years is a long time at your age & stage in life, and I would guess the annual change is capped, so you may have a few extra years beyond the 10 at not too bad rates?

Later, if you think you are likely to go much beyond 10 years there, you can look into a refi.

-ERD50

 

[athena53]

Ordinarily ARMs scare the crap out of me but having the interest rate fixed for 10 years is a pretty good deal.

Worst cases, which you should probably consider: years ago in NJ I knew a couple living in a condo with their 3 little kids. They'd bought it as newlyweds but then mortgage interest rates rose, meaning the market value of the condo declined, and they'd have to bring $$ to the closing. They waited out the market and were finally able to sell the condo and buy a home better-suited to their family. As far as refinancing, many people who wanted to do that after their ARMs reset during the Subprime crisis found that the value of their homes had decreased to the point that the banks wouldn't do it- even if they'd been making the payments on time.

But then the whole home ownership thing is a risk, anyway!

 

[Montecfo]

The 10-1 ARM seems to be a no brainer.

I usually did fixed rates early in my home owning years. When I bought current home I did a 7 year balloon, then refinanced into 5-1 ARMs that have worked out fabulously. I believe I am in year 10 or 11 with the last one. They followed the rate drops down. Now at 2.65% for another 2-3 yrs.

Would you take out an insurance policy today against the possibility of a rate rise in 10+ years that is only effective as long as you own that home and have the current loan in place? And if so, what are you willing to pay for it? Those are the questions.

 

[brewer12345]

Option 2 as long as you can handle the downside risk upon reset. Figure out the balance in 10 years and calculate the max payment if the rate jumps as much as possible. If you could still make the monthly, it is a no brainer.

Would you mind saying who the lender is?

 

[younginvestor2013]

Thanks all. A 15 year fixed is an option, it would be about $700 more a month than option 1&2. Frankly I would rather have the extra free cash flow, and additional tax break, of options 1&2 so that I can continue to sock away in my 401k.

I think my thought process, which is leaning towards option 2, is as follows:

If I do the 10 year ARM and actually end up wanting to keep the unit beyond year 10(which is unlikely but who knows) I would either refi to a lower rate (which is a bit of a gamble) OR if rates are unfavorable I would pay off the mortgage entirely.

If I continue to save what I have historically been saving and assuming a moderate annual return rate of 5-6%, my nest egg should be around $1m-1.3m and the mortgage balance at year 11 would be around $280k.

I think it is likely that I will either have sold my place and moved by then at which point I would be susceptible to the current market mortgage rates anyway.

 

[Scuba]

Thanks all. A 15 year fixed is an option, it would be about $700 more a month than option 1&2. Frankly I would rather have the extra free cash flow, and additional tax break, of options 1&2 so that I can continue to sock away in my 401k.

I think my thought process, which is leaning towards option 2, is as follows:

If I do the 10 year ARM and actually end up wanting to keep the unit beyond year 10(which is unlikely but who knows) I would either refi to a lower rate (which is a bit of a gamble) OR if rates are unfavorable I would pay off the mortgage entirely.

If I continue to save what I have historically been saving and assuming a moderate annual return rate of 5-6%, my nest egg should be around $1m-1.3m and the mortgage balance at year 11 would be around $280k.

I think it is likely that I will either have sold my place and moved by then at which point I would be susceptible to the current market mortgage rates anyway.

If paying off your mortgage is a potential strategy down the road, are you setting aside some $$ in a taxable portfolio you can access penalty-free? We did that and it was a key enabler for a low stress ER.

 

[rk911]

15-yr fixed, min 20% down, do your own escrow, piti psyment no more than 25% of take home pay.