Author Topic: Help me understand the mechanics of extra principal payments  (Read 1002 times)

NorCal

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I just went under contract for our first home, and we are at the decision point of fixed vs. variable rate mortgage.  I almost took the 30yr fixed by default, but I questioned that once I saw the ARM rates.  Current rates are 4.5% for the 30yr and 3.875% for a 7/1 ARM.

Our plan is to pay the mortgage off in 5-10 years assuming all goes well.  A 10 or 15 year fixed would be a bit too tight in the near term, as I am currently job searching in our new city.  But once I have a new job (and my eldest is done with daycare next year), we'll be back to the high savings rate.

My question is what happens to monthly payments when the ARM rates reset?  I know the interest rates go up and down to reflect current rates on a 30yr amortization schedule.  But how do they recalculate the payments when additional principal has been paid down?  I assume they don't reset payments to push the payoff to the 30 year mark.

sokoloff

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Re: Help me understand the mechanics of extra principal payments
« Reply #1 on: July 04, 2018, 12:38:45 PM »
Having never had an ARM, this is only a guess, but I'd guess they do one of two things:
1. Recast the mortgage, so the payoff term remains at a total of 30 years. This would have the effect of reducing your minimum required monthly payment.
2. Continue along an original amortization schedule with respect to principal payments and then layer on the required interest amount. This would have the effect of still lowering your payment (in any constant interest rate environment), but not by as much as in #1 and would not have the effect of keeping the term at a total of 30 years.

If you're planning to pay off in 5-10 years, saving 5/8ths for the 7/1 may make sense. (It also serves as a good forcing function. :) ) If you're not planning to pay off that aggressively, I would stick with a conventional (fixed) mortgage.

(A quick google search didn't turn anything up for me either. I'm sure you could read the terms of the mortgage and puzzle out the actual math, but if you plan to pay off in 5-10, you will have such a small balance left at the start of year 8, that I'm not sure the math matters all that much in a practical sense.)

NorCal

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Re: Help me understand the mechanics of extra principal payments
« Reply #2 on: July 05, 2018, 12:02:28 AM »
Thanks.  I assume #2 is probably how they manage it.

I want to build a spreadsheet to figure this out.

My current hypothesis is taking a 7/1 ARM, but making comparable payments as required by the 30yr fixed would almost always put you in a better spot.

For example, imagine your ARM had a min payment of $1,000/mo, and your 30yr fixed had a payment of $1,100/mo.  If you made $1,100 payments on your ARM for 7 years, interest rates would have to move a LOT for your payments to actually go up.  They would most likely go down, even if interest rates moved against you.

Or am I overthinking this?

Dicey

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Re: Help me understand the mechanics of extra principal payments
« Reply #3 on: July 11, 2018, 07:54:19 PM »
Paging @boarder42.
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RWD

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Re: Help me understand the mechanics of extra principal payments
« Reply #4 on: July 11, 2018, 07:59:52 PM »
Have you considered not paying extra principal and investing instead?
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boarder42

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Re: Help me understand the mechanics of extra principal payments
« Reply #5 on: July 11, 2018, 08:57:11 PM »
Taking ng the 30 year and holding it to term is likely the best choisy in this situation and an option you haven't considered it seems. I was like you when I showed up bc this line of thought is counterintuitive. If you sock your extra money into equities you're extremely likely to come out way ahead historically. We're talking about shaving a year or two off your FIRE timeline and increasing your financial saefty on the way to FIRE. I know all of this seems strange bc we're supposed to hate debt and hey mmm paid his off so it's the right thing to do. Wrong mmm paid his down in a very different rate environment. And had he been saving up now I think his post on mortgages vs no mortgage would be incredibly different.
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Dani S

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Re: Help me understand the mechanics of extra principal payments
« Reply #6 on: July 12, 2018, 11:35:14 AM »
Paging @boarder42.

Haha when I saw the title I was expecting to see boarder here "The mechanics of extra principal payments is you not making them." and you didn't disappoint @boarder42

NorCal

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Re: Help me understand the mechanics of extra principal payments
« Reply #7 on: July 13, 2018, 10:57:29 AM »
I completely get the arguments for investing money instead of paying down a mortgage.

Personally, I agree with that logic in some cases, but not all cases.  I don't really want to re-hash all of those arguments here.

In my case, I do plan to invest heavily, and we are carrying more of a mortgage than we have to.  However, I do want to pay it down before quitting a job in the 5-10 year time-frame.

Here's the specific problem I'm trying to optimize.  In addition to the below, I would put half of our annual bonus towards principal pay-down while investing the other half.

Option #1:  $530K mortgage, 7/1 ARM at 3.875%. Monthly minimum P&I~ $2,500
Option #2:  $530K mortgage, 30yr fixed at 4.5%.  Monthly minimum P&I ~ $2,700
Option #3:  $530K mortgage, 7/1 ARM at 3.875%. Make $2,700 monthly payment (similar to the 30yr fixed) to be in a better position when interest rates reset.

Considerations:  The 3.875% rate has a discount applied.  When rates reset, they will be at LIBOR + 2.25%.  It's hard to imagine rates not going up based on this.  However, taking an extra $200/month and either investing it (option #1) or paying down principal (option 3) seems like it would leave us in a much better position in seven years.

I hope to build a spreadsheet for this over the weekend, but dealing with movers and utilities will probably be the priority.




sokoloff

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Re: Help me understand the mechanics of extra principal payments
« Reply #8 on: July 13, 2018, 11:05:24 AM »
If option 4 includes paying $5350 principal and interest per month on the ARM, itís a clear winner vs option 5 paying $5500 P&I per month on the 4.5% loan.

If youíre only planning to pay $2700 per month, youíre still going to owe a crapload of principal at the quit-job mark. If youíre going to stay in his house after quitting and only planning to pay $2700/mo, I think the 30 fixed is better.

FIRE@50

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Re: Help me understand the mechanics of extra principal payments
« Reply #9 on: July 13, 2018, 11:23:13 AM »
If you are truly going to pay off the mortgage in 5-10 years, taking the guaranteed lower rate for anywhere from 70-140% of that time frame seems like a no-brainer to me.

You should also check into what the maximum rate increase is per year. That will give you the worst case scenario for years 8-10.

boarder42

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Re: Help me understand the mechanics of extra principal payments
« Reply #10 on: July 14, 2018, 12:14:02 PM »
I have no more comments if youre going to make a riskier longer to fire decision.

I don't believe you understand the argument if you did you would have real reasons why other than before I fire. And you're 5-10 years out so investing the difference will be huge over that time frame
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clarkfan1979

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Re: Help me understand the mechanics of extra principal payments
« Reply #11 on: July 14, 2018, 02:54:01 PM »
I would take the 30-year fixed at 4.5%.

When you get a low interest rate for borrowing money, you can maximize the low interest rate by paying it off slowly. If you hurry to pay it off, the value of the low interest rate goes down.

I have some student loans at 3.03% that are about 7 years old. Should I pay them off asap or pay the minimum and invest the difference?
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Telecaster

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Re: Help me understand the mechanics of extra principal payments
« Reply #12 on: July 14, 2018, 04:05:21 PM »
30 year fixed at 4.5% is the deal of a life time.


NorCal

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Re: Help me understand the mechanics of extra principal payments
« Reply #13 on: July 14, 2018, 04:37:26 PM »
Thanks everyone for the inputs.  I appreciate the opinions, particularly the critical ones.  You made me look at my plans with a more critical eye, and be more careful with my math.

I built a spreadsheet, with different variables for payments and future interest rates.

If we lived in a time when stocks were cheap, I could buy a rental property for a good price, or bonds were yielding more than ~2%, I'd absolutely take the fixed rate mortgage and pay it as slow as possible.  However, from where we are today, I'm not convinced my other investment options would yield more than 3.9% over the next decade.  Fundamentally, I take the view that forward returns from today will be materially lower than 7%, although I do believe the stock market will maintain that average over the long term.

Right now, I'm most comfortable with the ARM, and building extra payments into our investment policy.  We'll do something along the lines of 33% of our excess cash flow (after maxing retirement plans) will go to excess principal payments, with the remainder going towards investments.

This will put us in a spot in 8 years where changes in rates shouldn't impact us much.  And if rates go wonky on us, we already have enough in investments to pay off the home in full.

boarder42

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Re: Help me understand the mechanics of extra principal payments
« Reply #14 on: July 14, 2018, 06:42:08 PM »
You're not compaing numbers correctly.

1 you're looking at real returns on markets so you should deduct inflation from your mortgage so if 3.9 is your expectation the the mortgage is effectively 1.5% since it doesn't index to inflation.

2nd you're market timing and hiding behind the emotional side of a mortgage using it to make you feel better. The same statement could have been made and has been made the last 5 years about market returns. It's been wrong. You're effectively using the debate that shouldn't be a debate to hide market timing as long as you understand you're doing that more power to ya but you're stastically going to fail.
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Kyle Schuant

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Re: Help me understand the mechanics of extra principal payments
« Reply #15 on: July 14, 2018, 07:01:27 PM »
Your country really needs to discover offset accounts.
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boarder42

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Re: Help me understand the mechanics of extra principal payments
« Reply #16 on: July 14, 2018, 07:47:13 PM »
Your country really needs to discover offset accounts.

We have these they are dumb wastes of money at the interest rates we can obtain. They make sense for liquidity in a country with crazy real estate prices and interest like yours.
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