Monday, November 13, 2006

Why I love my Adjustable Rate Mortgage

Okay so most people say "ugh no way, awful, too risky." I say hold on, it depends on why your getting one and what type of adjustable mortgage. I'm going to discuss the different types of adjustable mortgages, the pros and cons, and why I personally chose an adjustable mortgage.

First an Option-Arm mortgage, which gives you the opportunity to pay as much or as little as you want per month. If you don't pay all the interest it just ballons up and you owe more than the house. Pro, very low monthly payment. Con, obviously you can owe more than your house is worth. Whose it for? People who have variable incomes, and maybe have some lean months, but some great times, so they can pay it off. Great for people who maybe have huge bonus or commission checks. Not great for people stretching to buy a home. Also good for people interested in paying off the home super fast.

Second, Interest-Only Arm, a mortgage where you only the interest on the loan. Here typically you have a set number of year 3,5, or 7 where you only pay the interest on the loan. Then it reamoratizes and you have to pay the pricipal down faster in the remaining years along with potentially the higher rate at the new adjustment. Pros again low monthly payment. Cons, if housing prices go down, you've built no equity up to cushion yourself. You could owe more than the home is worth. This is mostly for times when homes are going up, if it's going down, you may not have a valuable asset at the end. So it's probably for people who like risk, are going to move or have an increase income soon, and the market is going up instead of down.

Finally the typical adjustable rate mortgage, where it stays fixed for 1, 3, 5, 7, or 10 year, then adjusts annually afterwards. Typically your mortgage is amortized from the beginning, and there is an annual and lifetime cap on rate increases, usually 2% annually and 5% lifetime. Pros, good for people who expect more income, want to move, or plan on paying it off in this fixed time period. Cons, you could end up with a high rate and owing a lot more later.

We went with the typical adjustable rate mortage for a 7 year fixed period. I love our rate 4.25% with a lifetime cap of 5%, so the most we'll ever pay is 9.25% if we stayed here forever. Now what that means we will owe after 7 years approximately $400k on our home if we made minimal payments. Then if it adjusts to 9.25% our payments will go from $2263 to $3504, more likely the rate will be 7.25% so our mortgage will be $2982. If we had done the 30 year fixed for 6% the payment would have been $2757.

Now, look at that, our rate at the absolute highest will be only $750/month more than the fixed rate. Is that a big deal, in 7 years I don't think so. Would it be a big deal now, not really. Could we manage it? Yes. Chances are we'll still pay less overall because of the lifetime cap when compared to the 30 year fixed.

Why'd we choose the ARM then? Was it for the lowest payment? Yes. But we had other factors such as we knew we'd have an increase in income before then. One DH just got a job so his salary now is not where it will be in 7 years. Two, I'm in school so my income isn't close to where it will be in 7 years. What if your a SAHM though? I don't make much now, we're not using my income to live on really so no big difference there. And DH's income is still going up because he's also in school part-time for another degree (what can I say, we're addicted to degrees). So I think the likelyhood of our income increasing is close to 100%.

Second, we don't love our home enough to live here forever. Hey we live in the NE in a super expensive area, we bought a townhouse (3 bd/2.5ba with connecting walls). Ugh, no we want to live one day in a single family home. I forsee when we finish with school moving again, probably within 7 years. Also everyone knows we hate it out here, we're moving back to the West Coast as soon as school is done.

With those 3 reasons in mind, we knew that we were in a position to financially buy a home with an ARM.

But what if we want to keep the home and rent it out? No we aren't the landlording type, or else we would have kept our cheap place in SD. No we need the equity probably for our next place.

Finally our home is not an investment, it's just a nice place to live without moving. So if we don't earn much on it in the next 5-7 years, it's okay. This way we're paying minimal interest to borrow money for a very slowly appreciating asset. And we're minimizing our potential losses, while maximizing our retirement and taxable accounts with cash in hand. Homes still are ill-liquid assets.

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