Being Realistic Saves Money on your Mortgage
If you haven't heard about the thirty year fixed rate mortgage, welcome to planet earth and I hope we can be friends.
The thirty year fixed rate loan seems to be the holy grail of all mortgages. It's what everyone wants, and what they're calling about when they call me to talk about refinancing a loan.
Well, it is secure, and it is something you can count upon today, tomorrow, and next week, etcetera, until the mortgage will theoretically be paid off.
The problems are three fold: First, it is the most expensive loan out there. It always has had the highest rate of any loan available, and always will (Except for the 40 year loan which is making a comeback for no particularly good reason, and the fifty year loan which is a brand new waste of money). This means you are paying more in interest charges every month for this loan. Second, according to data gathered by our government, the vast majority of the public will refinance or move about every two years, whether they need to or not, paying again for benefits they paid for last time, and didn't use. This is essentially paying for 30 years of insurance your rate won't change, and then buying another 30-year policy two years down the road, then another two years after that, etcetera. Finally, because it is always the highest rate and this is what everyone wants, many mortgage providers will play games with their quote. They will quote you a rate on a "thirty year loan", meaning that it amortizes over thirty years, not that the rate is fixed the whole time. Or they'll even call it a "thirty year fixed rate" loan, but the rate is only fixed for two or three years. Every time you hear either phrase, the question "How long is the rate fixed for?" should automatically pop into your mind and proceed from there out of your mouth.
The fact of the matter is that there are other loans out there that most people would be better off considering. In the top of the loan ladder "A Paper" world, there are thirty-year loans that are fixed for three, five, seven, and ten years, as well as interest only variants and shorter-term loans (25, 20, 15, 10, and even 5 year loans). The shorter-term loans tend to be fixed for the whole length, but of course they require higher payments.
I personally would probably not even consider a 30 year fixed rate loan for myself, and here's why. First, the available rates go up and down like a roller coaster. They are the most volatile rates out there. Given that I will lock it as soon as I decide I want it, it's still subject to more variations that any other loan type. Back when I bought my first place, thirty year fixed rate loans were running around ten and a half percent. Five years before that, they were fourteen percent and up. Second, having some mortgage history, I can tell you I refinance about every five years. Why would I want to pay for thirty years of insurance when I'm only going to use about five?
Even in the summer of 2003, when I could do a 30 year fixed rate mortgage at 5 percent without any points, I could do a 5 year ARM (fixed for five years, then goes adjustable for the rest of thirty) for four percent on the same terms. I keep using a $270,000 mortgage as my default here, so let's compare. The 30 year fixed rate loan gives you a payment of $1449, of which $1125 is interest and $324 is principal. The five-year fixed rate loan gives me a payment of $1289, of which $900 is principal and $389 is principal. I saved $225 in interest the first month and have a payment that is $160 lower, while actually paying $65 more in principal. What's not to like? If I keep it the full five years, I pay $51,549 in interest, pay down $25,791 off my balance if I never pay an extra dollar, as opposed to paying $64,903 in interest on the thirty year fixed rate loan, while only paying down $22,062 of my balance - and I've got $13,500 in my pocket, as well as the $13,300 in interest expense I've saved and $3700 lower balance. If I choose the five-year ARM and make the thirty-year fixed-rate payment, I cut my interest expense to $50,539 while paying off $36,426 of principal (remember, every time I pay extra principal it cuts what I owe, and so on the amount of interest I pay next month.). If I then pay $3500 to refinance, adding it to my balance, I have saved many times that amount. I still only owe $237,074, as opposed to the 30 year fixed rate loan, which has a balance of $247,938. That's over $10,800 off my balance I've saved myself, plus over $14,300 in interest expense, simply by realizing that I'm likely to refinance every five years. And the available ARM rates are more stable as well as lower. From the first, I haven't had one with a rate that wasn't in the sixes or lower. Finally, if I watch the rates and like what I see and so I don't refinance, I'm perfectly welcome to keep the loan. And all of this presumes that the person who gets the thirty-year fixed rate loan doesn't refinance or sell the home, which is not likely to be the case. Statistically, the median mortgage is less than two years old, and less than 5 percent are five years old or more.
At rates prevailing today, I can get the same loans at 5.75 and 5.125 percent (without points. Note: This was written a while ago, and rates are higher now), respectively - which is about the narrowest I've ever seen the gap. Assuming a $270,000 loan, for the 30 year fixed rate loan that gives a payment of $1576, which five years out means that I have paid just under $74,996 of interest, $19542 of principal and have a balance of $250,457. If I choose the 5 year ARM, my payment is $1470, so if I keep it five years I've paid $66,581 in interest, $21,626 in principal, and my balance is $248,373. Plus I've kept $6300 in my pocket, or alternatively, if I used the $106 per month to pay down my loan, I've only paid $65,713 in interest, have paid $28,826 in principal, and have a balance of $241,174. Even if I then add $3500 in order to refinance and the thirty year fixed rate does not, I'm still ahead $5700 on my balance plus the $9200 in interest I've saved, and the chances of the person who chose the thirty year fixed rate loan not having refinanced is less than 5%.
ARM mortgages are not for everyone. If you're certain you are never going to sell and never going to refinance, it makes a certain amount to sense to go for the thirty year fixed rate loan. And of course, if you're going to lie in bed awake every night worrying about it, the savings work out to a few dollars a day and my sleep is worth more than that to me, and so I'm going to presume it is to you, as well.
But what most people should be trying to do is cut interest expense while not adding any more than necessary to the loan balance. As I've gone into elsewhere, money added to your balance sticks around an awful long time, usually long after you've sold or refinanced, and you end up paying interest on it, as well.
So even though various unethical loan providers tend to quote you rates on loans that aren't really what you are looking for if you want a thirty year fixed rate loan, they're actually doing you a favor in an oblique and unintentional way, and somebody who is up front about offering you a choice between the thirty year fixed rate loan and an ARM is quite likely trying to help you. Consider how long most people are likely to live in their home (average is about nine years right now), how long they're likely to go between refinancings (less than two years), and your own mindset. It is quite likely you can save a lot of money on ARMs. Why pay a higher interest rate in order to buy thirty years of insurance that your rate won't change, when you're likely to voluntarily abandon it about two years from now anyway? Why not just buy less insurance in the first place?
UPDATE: I had someone question the numbers in the paragraph comparing the 4% 5/1 ARM against the 5% 30 year fixed rate loan, both of which were available at the same time in the summer of 2003. Now I have had it pointed out to me that I made a mistake in calculations somewhere. The numbers for interest and balance savings are correct, but those for payment savings are $9623, not counting the time value of money. Your savings are not the sum of the three numbers. It depends upon your point of view as to which is most important to you. The interest savings and the dollars in your pocket plus lowered balance are essentially the same dollars. They are two sides of the same coin. It's just a question of what you're most interested in. Not that $13,000 plus is chump change, even on this scale, and no matter how you look at it, you're $13,000 plus to the good. You've either got $9623 in payment savings plus $3670 in lowered balance, both of which are "in your pocket" in one sense or the other. You wrote checks totaling $9623 less, and you've got $3670 in lowered balance, which translates to increased equity - not to mention that you're not paying interest on it any longer. Or you could look at it as simply 13,000 plus in interest you didn't pay. Most folks will lose some of the interest in the form of taxes they don't pay, but 1) That's never dollar for dollar and 2) I wasn't going that deep when I wrote this article.
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