Employee mortgage rate calculation help needed

[dragonwalker]

My work has an interesting employee mortgage program which I am considering using for the purchase of a 2B/2B condo to live in and rent 1 room in southern CA. I was qualified for a loan of $280,000. I am not looking for an opinion about the merits of whether I should buy one but rather what is mathematically the best financing option.

The calculation for the employee rate is based on cost of funds and a 0.150% margin which will currently come out total for the next quarter of 0.89% or a P&I of $887. It is an ARM that adjusts every quarter.

The cost of funds for our institution looks to be tied into the federal funds rate. I had to look back till 2006 to really look at how our employee rates adjust under a higher interest rate environment. I tracked the changes in the fed funds rate and its impact on our rate against the information I could find on Freddie Mac’s average home rates during that period.
My conclusion is that our company rate fluctuated in pretty much lock step with changes in the fed funds rate and maintained consistently about 2-3% lower than the equivalent market rate for 30 year fixed mortgage offered at time by Freddie Mac with average 0.5 pts.
   
If I assume at this time I can expect to get around 2.9% on $280K for a 30 year fixed rate my mortgage would be about $1166 ($489 principal and $677 interest starting out) compared at 0.89% $887 ($679 principal and $208 interest). That a monthly interest savings of $469 a month and nearly $200 more to principal a month. Now I know the difference between these margins will close over time only assuming the ARM rate stays the same which ofcourse it won’t.

The tricky thing is determining which one to take. I can very confidentially say that I’m likely to stay at my employer for at least 6 years because I’m looking to start an MBA program reimbursed mostly by work which will take almost 3 years and I will need to stay 3 years beyond that not to have to repay anything. 6 more years will put me at 39. I don’t have a family now or kids, but I am thinking it’s possible in this time that may change. I’m making assumptions here but I’m going to say even if I had a kid within the next year (I have no plans) there would be no issue continuing to live in the condo I have. In the long term with rates so low and bound to go up I’m probably looking at needing to refinance or sell.

I’m going to make a few more assumptions, looking at the history of the fed funds rate I’m going to take the period from 12/21/15 to 12/17/18 as the model of how quickly rates may go up. The rate in Dec. 2015 was 0.36% increasing steadily till Dec. 2018 to 2.40% average quarterly increase of 0.17%. The impact this had on the Fannie mortgages was that in Dec 2015 average rates were 3.96% with 0.6 pts increasing to average of 4.64% 0.5 pts while the rate at my work changed from 0.764% to 1.493% in that same period. What would the break-even point be at least as far as time is concerned? I hope I am making sense here just trying to make my dollar go as far as it can.   

[Abe]

It seems you should just do the employee one until the rate exceeds standard rates, then refinance.

[dragonwalker]

It seems you should just do the employee one until the rate exceeds standard rates, then refinance.

@Abe I don't understand that at all. As the employee rate goes up so will the 30 year fixed rate. The question is how long would I have to stay in a home before it makes more sense to get a fixed now at 2.9% for the long haul.

[yachi]

I’m going to make a few more assumptions, looking at the history of the fed funds rate I’m going to take the period from 12/21/15 to 12/17/18 as the model of how quickly rates may go up. The rate in Dec. 2015 was 0.36% increasing steadily till Dec. 2018 to 2.40% average quarterly increase of 0.17%. The impact this had on the Fannie mortgages was that in Dec 2015 average rates were 3.96% with 0.6 pts increasing to average of 4.64% 0.5 pts while the rate at my work changed from 0.764% to 1.493% in that same period. What would the break-even point be at least as far as time is concerned? I hope I am making sense here just trying to make my dollar go as far as it can.

It makes logical sense that your company's internal rate would be correlated to the federal rate, but I don't see that in these data points.
The Dec 2015 rate at your work was double the Fed rate, or 0.404 percentage points higher, while the Dec 2018 rate at your work was 62% of the Fed rate, or 0.9 percentage points lower.  That leads me to think either these rates are not tied together at all, or someone held your internal rate lower on purpose to preserve the discount to prevailing mortgage rates.

Your work rate was more in line with mortgage rates, at about 3 percentage points lower than the mortgage rates at each endpoint.

If the internal company rates are being influenced to keep them competitive, then they could very quickly adjust in the future.

[Abe]

It seems you should just do the employee one until the rate exceeds standard rates, then refinance.

@Abe I don't understand that at all. As the employee rate goes up so will the 30 year fixed rate. The question is how long would I have to stay in a home before it makes more sense to get a fixed now at 2.9% for the long haul.

It was hard to figure that was your question since you were comparing two rates with different structures, so I assumed your question was about those structures. See yachi’s post about correlation or not with the fed rates. Cant you just ask the employer how they determine rates?
 Anyway, if your question is “how long do I need to stay somewhere to make it worth to buy”, you can use The NY Times’ calculator to help you figure that out: https://www.nytimes.com/interactive/2014/upshot/buy-rent-calculator.html
If your question is “which mortgage structure to go with” my answer would be the same. Go with the lowest rate and refinance when the rate is adjusting up to the 30 year fixed at a given time. If it is always below the 30 yr fixed, then don’t.

[ender]

What happens to this mortgage if you leave your employer?

[dragonwalker]

It seems you should just do the employee one until the rate exceeds standard rates, then refinance.

@Abe I don't understand that at all. As the employee rate goes up so will the 30 year fixed rate. The question is how long would I have to stay in a home before it makes more sense to get a fixed now at 2.9% for the long haul.

It was hard to figure that was your question since you were comparing two rates with different structures, so I assumed your question was about those structures. See yachi’s post about correlation or not with the fed rates. Cant you just ask the employer how they determine rates?
 Anyway, if your question is “how long do I need to stay somewhere to make it worth to buy”, you can use The NY Times’ calculator to help you figure that out: https://www.nytimes.com/interactive/2014/upshot/buy-rent-calculator.html
If your question is “which mortgage structure to go with” my answer would be the same. Go with the lowest rate and refinance when the rate is adjusting up to the 30 year fixed at a given time. If it is always below the 30 yr fixed, then don’t.

So to quote from my employer's policy it states that the employee program is a variable rate program that uses an index value plus a margin. The margin is calculated using the interest expense on deposits and borrowings for the calendar quarter, divided by the actual number of days during the quarter, multiplied by 365 and divided by the average daily balance of deposits and borrowing during the quarter. Therefore my conclusion is that although there is a correlation to the fed funds rate it is by no means the same. Interestingly there is a provision that says if our interest rate is lower than the Applicable Federal Rate (APR) than there would be some imputed income. I found out the APR is a federally decided minimum rate that can be charged on loans and anything lower I will have to pay imputed income on my W2. Our rates have gone below this in several times in the past 5 years resulting in imputed income of between $400 to $1200 annually per $100K borrowed. In theory I suppose that is a good thing because that means my interest rate is so low that it's below federal guidelines and I have to pay tax on income imputed. Interestingly there was no imputed income from 2020 since the AFR rate dropped to below 0.25%.

The one issue with your idea Abe is that let's say I keep this condo for the long term say even 30 years than wouldn't it mean eventually I would end up paying more having this employee rate because historically the interest rates have averaged much higher than the 2.9% I think I can lock in now. The employee rate would always be lower than the market 30 year fixed but is 2-3% lower enough to mean that I will be paying less over the long run? That's the essence of my question assuming growth in rates at a rate to the historical average is it better to fix it now?

@ender should I leave the company than my mortgage reverts to a standard 5/5 ARM that any member can get.

[AMandM]

I think I understand your question. If you take the employer plan, but a year from now the rates are so high that even your below-market rate is 3%, you'll with you had a 30-year mortgage at 2.9% instead of 1 year at 0.89% followed by 29 years at 3% or more.

You're essentially asking how fast/how soon interest rates will rise. If we knew the answer to that question, we'd all be on the post-FIRE board. ;-)

[reeshau]

Fed Chair Powell has testified that the Fed expects to keep interest rates at near-zero levels until 2023.  However, if inflation did appear in some form before this, he would change his mind and raise rates.   The Fed has also said it would let inflation overshoot their 2% target before acting, so they will be chasing it rather than trying to predict it.  I read this to mean that whenever it will happen, it will happen fast--perhaps faster than processes like mortgage refinance can react to.

You mention taking out a 30-year mortgage, but how long would you intend to keep it?  If you are the type for whom paying off a mortgage early is a dumb move, then I would suggest taking one now and locking in historically low rates.  To me, optimizing your payments for 3 years doesn't outweigh the assurance of minimum costs over 30 years.  You might play with the ARM for a couple years, based on the Fed's current position, but then you're in the futile business of predicting the Fed.

If you are the type who would pay it off early anyway, then you might lower your rate with a 15-year fixed loan.  It would still be dumb to optimize the first 3 years of that, a the cost of the last 12.

I also worry that the timeframe you are analyzing is the blink of an eye when considering housing.  My first mortgage in 1996 was at 8%.  I was thrilled to refinance at 6%.  The numbers now are not normal, and there is nothing that says global finance has moved so that those more-rational numbers can't happen again.  How happy will you be chasing the current spread for 6 years, vs. how sad you would be to be paying historically average rates?

[dragonwalker]

Fed Chair Powell has testified that the Fed expects to keep interest rates at near-zero levels until 2023.  However, if inflation did appear in some form before this, he would change his mind and raise rates.   The Fed has also said it would let inflation overshoot their 2% target before acting, so they will be chasing it rather than trying to predict it.  I read this to mean that whenever it will happen, it will happen fast--perhaps faster than processes like mortgage refinance can react to.

You mention taking out a 30-year mortgage, but how long would you intend to keep it?  If you are the type for whom paying off a mortgage early is a dumb move, then I would suggest taking one now and locking in historically low rates.  To me, optimizing your payments for 3 years doesn't outweigh the assurance of minimum costs over 30 years.  You might play with the ARM for a couple years, based on the Fed's current position, but then you're in the futile business of predicting the Fed.

If you are the type who would pay it off early anyway, then you might lower your rate with a 15-year fixed loan.  It would still be dumb to optimize the first 3 years of that, a the cost of the last 12.

I also worry that the timeframe you are analyzing is the blink of an eye when considering housing.  My first mortgage in 1996 was at 8%.  I was thrilled to refinance at 6%.  The numbers now are not normal, and there is nothing that says global finance has moved so that those more-rational numbers can't happen again.  How happy will you be chasing the current spread for 6 years, vs. how sad you would be to be paying historically average rates?

As I mentioned I am confident that I am likely to stay in any new place for at least 6 years. Beyond that it becomes less predictable but knowing myself being a creature of habit my natural inclination would be to continue staying or at least try to hold onto the unit. However if I held onto the unit as an investment property than I would have to give up my employee mortgage rate and switch to a regular 5/5 ARM or refinance.

In theory locking in a low 30 year fixed might be a better option in this scenario however the two issues are affordability and opportunity cost. Under my single income my loan qualification amount is sitting around $280K allowing for about a $400 HOA. That works out to a 20% down on a place that is $350K. At $350K I can hope to find what I am looking for but any less and I would priced out of the market unless I wanted to increase my down but I see that as less optimal because rates are so low it makes more sense to keep my money invested elsewhere rather than locked into the home. For example I would have to put down an additional 65K to bring the monthly P & I on a 30 year fixed to the current payments I would pay on the ARM.

Now I have a net worth  of about $700K ($200K in 401K/IRAs) and $200K of the remaining from capital gains growth. Therefore to get $65K more I would be looking at not only selling more investments but also paying about $50K in long term capital gains taxes from what I would likely sell. This lets be get a fixed mortgage of $215K @ 2.9%. After all this at the end of the day if I don't end up keeping it long term than I've lost out on the extra interest paid in the meantime, opportunity cost and taxes paid on capital gains.

Looking at what I have to do and the likelihood of increased rates I'm looking for the best option. Does my concern make sense to you guys? 

[maizefolk]

Looking at what I have to do and the likelihood of increased rates I'm looking for the best option. Does my concern make sense to you guys?

The concern makes sense, but I think you may be asking for an answer neither we nor you can give without additional data we don't have: how soon and how fast interest rates are likely to rise. We can do all sorts of math and reasoning but without that missing puzzle piece there just isn't going to be a clear and universal answer out there for you.

Let me ask you a different question:

What is your emotional/gut level view of risk and uncertainty?

The employer offered mortgage could certainly pay off -- depending on what interest rates do -- and my guess is that if we looked at 100 different possible futures, on average you'd be better off with the below-market variable rate than an at-market fixed rate. However if we look at the possible futures with the worst outcomes, the worse case scenario outcomes are always going to be much less bad for a fixed rate than a variable rate.* The choice you are facing is mathematically quite similar to the one of whether to lump sump invest into the market vs dollar cost averaging. Lump sump maximizes average return across many possible futures. Dollar cost averaging trades a little average return to make the worst possible futures significantly less bad.

So, as a person who knows you best, do you think you are the sort of person who cares more about maximizing how good your average possible outcome is or or the sort of person who cares more about making sure the least bad outcomes aren't so bad?

*Just ask the people in Texas had Griddy as their electricity provide (sold power at whatever current wholesale prices were, even when those prices when up to $9/kilowatt hour.)

[dragonwalker]

Looking at what I have to do and the likelihood of increased rates I'm looking for the best option. Does my concern make sense to you guys?

The concern makes sense, but I think you may be asking for an answer neither we nor you can give without additional data we don't have: how soon and how fast interest rates are likely to rise. We can do all sorts of math and reasoning but without that missing puzzle piece there just isn't going to be a clear and universal answer out there for you.

Let me ask you a different question:

What is your emotional/gut level view of risk and uncertainty?

The employer offered mortgage could certainly pay off -- depending on what interest rates do -- and my guess is that if we looked at 100 different possible futures, on average you'd be better off with the below-market variable rate than an at-market fixed rate. However if we look at the possible futures with the worst outcomes, the worse case scenario outcomes are always going to be much less bad for a fixed rate than a variable rate.* The choice you are facing is mathematically quite similar to the one of whether to lump sump invest into the market vs dollar cost averaging. Lump sump maximizes average return across many possible futures. Dollar cost averaging trades a little average return to make the worst possible futures significantly less bad.

So, as a person who knows you best, do you think you are the sort of person who cares more about maximizing how good your average possible outcome is or or the sort of person who cares more about making sure the least bad outcomes aren't so bad?

*Just ask the people in Texas had Griddy as their electricity provide (sold power at whatever current wholesale prices were, even when those prices when up to $9/kilowatt hour.)

I totally get what you are saying here. I ran some more numbers under the following assumptions.

Just fyi the stock I would likely sell to make up my down to get a fixed rate mortgage would be Apple. Let's say we look at the first 6 years and set the following conditions. Let's say I calculate a rate of return annually including dividend reinvestment of 6% for Apple on $65K. At the end of 6 years I'm looking at about $92K. My fixed rate mortgage at 2.9% for the $215K I would have paid $35K in interest and principal down to $185K. Under the ARM program if I assume starting rate of 0.89 adjusting .25% annually by the end of the 6th year I would have paid $34K in interest and loan down to $237K. Considering the growth and value of the stock interest saved and principal balance the ARM at 6 years is ahead at nearly $40K! If I extend this out to 10 years the "ARM program" is ahead $56k and by 15 years it's ahead 73K. Even if I adjust the ROR on Apple to 5% I'm still clearly looking at the ARM being ahead. I stopped at 15 years because at that point it becomes to unpredictable and there perhaps another chance rates might start falling at some point during this time.

Even adjusting the ARM to 0.50% increase per year I'm still ahead calculated out to 10 years. at which point the ARM rate would be 6.5% at which point I can decide to refinance or sell on a principal of $217K.

[reeshau]

Looking at what I have to do and the likelihood of increased rates I'm looking for the best option. Does my concern make sense to you guys?

The concern makes sense, but I think you may be asking for an answer neither we nor you can give without additional data we don't have: how soon and how fast interest rates are likely to rise. We can do all sorts of math and reasoning but without that missing puzzle piece there just isn't going to be a clear and universal answer out there for you.

Let me ask you a different question:

What is your emotional/gut level view of risk and uncertainty?

The employer offered mortgage could certainly pay off -- depending on what interest rates do -- and my guess is that if we looked at 100 different possible futures, on average you'd be better off with the below-market variable rate than an at-market fixed rate. However if we look at the possible futures with the worst outcomes, the worse case scenario outcomes are always going to be much less bad for a fixed rate than a variable rate.* The choice you are facing is mathematically quite similar to the one of whether to lump sump invest into the market vs dollar cost averaging. Lump sump maximizes average return across many possible futures. Dollar cost averaging trades a little average return to make the worst possible futures significantly less bad.

So, as a person who knows you best, do you think you are the sort of person who cares more about maximizing how good your average possible outcome is or or the sort of person who cares more about making sure the least bad outcomes aren't so bad?

*Just ask the people in Texas had Griddy as their electricity provide (sold power at whatever current wholesale prices were, even when those prices when up to $9/kilowatt hour.)

This is well-stated, and is the real question at hand.  You can plug in numbers in any way to find scenarios you like or don't like.  @dragonwalker , only you know if you would freak out if you ended up upside-down 15 years from now, whatever you choose.  Make the choice you feel most comfortable with, and follow along so you can intervene before it gets totally out of control.  (avoid the worst case)  You are ahead of the pack just because you are thinking this far ahead.