Mortgage payoff early vs not - some questions

[firelight]

We are buying a house for 1.68M in Bay area with 25% downpayment and 1.75% interest rate(APR 2.175%) at 10/6 ARM. Currently, our principal + interest comes to $4501.27 per month. When we include hoa, insurance and property taxes, it goes up to $6200 per month. DH and I can afford to do extra principal-only payments on mortgage.

We are not sure how to calculate that on ARM and how to make sure we are using the full interest deductions.
1) What does $750,000 interest deductions mean? Is it 750k per year of deduction or is it over the life of the loan? For example, our loan is for 1.26M. Can we only deduct interest for 750k of that loan? How to calculate what that number is?

2) When does paying off early vs not make sense?

3) Is there any way to reduce the APR of the property? This is from Wells Fargo and they already gave their best for interest rate. I'm wondering if APR is just a formula result or is there any leeway in reducing it?

[MDM]

1) See p. 12-14 of https://www.irs.gov/pub/irs-pdf/p936.pdf

2) Pay off early when you don't expect your investments to earn a higher return than your mortgage interest rate (after tax for both numbers).

[nereo]

regarding #3 - get quotes from different lenders. There's a well-known "hack" (really just traditional negotiating) where you get a quote from a company like Better, then present that to your current or another lender and ask them to match or beat it, then repeat. Lately I've heard from several people who have had success demanding zero-fees for ReFi.
 Takes a bit of legwork but it can (sometimes) get you a better overall rate.  There's some things included in APR that have some wiggle room, other things that do not.

[PMJL34]

OP,

Why are you interested in an ARM loan? Is it because you don't anticipate living there long? Or is it because you plan to pay it off before the ARM expires?

What is your thoughts on 30 year loans?

Best of luck!

[Another Reader]

Wells Fargo is consistently higher priced than other originators.  Start with Aimloan.com to get a better feel for pricing.  You want a fixed rate loan, as you cannot predict rates in the future.  All indications are they are going up as inflation increases.

[firelight]

OP,

Why are you interested in an ARM loan? Is it because you don't anticipate living there long? Or is it because you plan to pay it off before the ARM expires?

What is your thoughts on 30 year loans?

Best of luck!

Thanks so much for all your replies.

We ran the numbers and found that in order to break even on interest, the ARM interest should go up to 6% or more for fixed to make sense (assuming we invest the difference or even apply the extra to principal - we plan to do one of these two things). Also, I'm confident the rates won't go up so much in ten years (it will definitely increase but not beyond 6%).

Also, we have enough assets to pay off the loan anytime. If I find that the rates are higher than what I'd like, I can always refi to a fixed 30 year (maybe higher rates than what is available now but I'll save more on interest now) or pay off the loan.

We plan to hold this property long term (if it makes any difference).

[PMJL34]

OP,

The fact that you are putting down 25% makes me think this is an investment property. This property also appears to be an affordable purchase for you and that you can pay the loan off at anytime.

As you know, banks love ARM loans. I have heard of success stories with ARM, but the overwhelming majority are unhappy endings. People also like to take ARMS to bet against the future, but it's not a good bet right now as rates are already at historical lows. I like to simplify things. ARM is not that different from car leases imo. If you plan to sell or pay off mortgage in 10 years, then go for it (but why if it's an investment property?). Outside of these two options, just take a 30 year. The reason is because no one knows what 10 years in the future will look like (not just rates, but your job, life, etc.). How much money will you really save with this ARM? Are you calculating the refi cost if you do decide to refi out?

I don't want to discourage you from the ARM, just providing food for thought.

Also to answer your question. It is mathematically/statistically never smart to pay extra on your 2% APR loan. Now if you want to increase cashflow, sleep better, and FIRE sooner, then there's a different discussion. 

EDIT: Just for fun, I'm going to make a wild guess based on your location and purchase price that you are mid-late 30s and are tech money/crypto. This crowd tends to go for ARMs  and regret it (YMMV of course). It's the survivorship bias where they think they can outsmart the market. 

[Dicey]

Also, I'm confident the rates won't go up so much in ten years (it will definitely increase but not beyond 6%).

Bwa Ha Ha Ha!

[firelight]

Tell me if what I'm thinking is right or wrong.

1) Mortgage rates go up (as everyone predicts), wouldn't stock market returns go up even higher? If inflation is so high, even then stock market investing is a better deal correct?

2) Mortgage rates go up by a lot but the worst my ARM can go is 6% (lifetime cap). I expect to have paid off most of my mortgage in the first ten years (FIRE and all). Is there a way the rates would go up beyond 6%?

[nereo]

Tell me if what I'm thinking is right or wrong.

1) Mortgage rates go up (as everyone predicts), wouldn't stock market returns go up even higher? If inflation is so high, even then stock market investing is a better deal correct?

2) Mortgage rates go up by a lot but the worst my ARM can go is 6% (lifetime cap). I expect to have paid off most of my mortgage in the first ten years (FIRE and all). Is there a way the rates would go up beyond 6%?

1) the correlation between mortgage rates and stock market returns is no where near that straightforward.  We've had many periods when the market has underperformed but mortgage rates have risen (because the Fed is fighting off inflationary woes, often at the expense of economic expansion).  We've also (very recently) had very low rates during both recessionary periods and during amazing market booms.

2) as discussed elsewhere, paying off your mortgage at an accelerated pace is rarely the best financial decision.
2a) rates in the early 1980s exceeded 10%, and at times were 14%.  Will we see that again?  Crystal ball hazy - ask again later.

[PMJL34]

OP,

It does indeed sound like you are trying to "time the market" and/or beat the market. I would agree with Nereo that both your points are flat out assumptions.

What i'll say is this: make sure the risk is worth the reward.

In this case, the risk is nowhere near the reward, imo because:

1. 10 years of mortgage payments only makes a small dent on the overall loan balance.
2. paying extra on a sub 2% loan is most likely stupid.
3. you can just as easily lock in a comparable rate that you never have to worry about aka 30 year loan.

ymmv and best of luck!

[nereo]

Just adding this in -

People (often very smart, economically-savvy folks) have been saying things like “we won’t see interest rates this low ever again” and “interest rates are going to rise significantly” for over a decade.  When I took out my first mortgage in 2012 I remember the loan officer saying those very things to me - yet rates are lower now than they were then, by a considerable margin.

[affordablehousing]

yes you can only deduct interest on $750K of the loan. Sounds like a cheap deal in the bay, jump on it! And that loan sounds fine. Just pay off the loan when it goes adjustable, EZPZ.

[Another Reader]

Also, I'm confident the rates won't go up so much in ten years (it will definitely increase but not beyond 6%).

Bwa Ha Ha Ha!

Yup.  Seen that movie too.

[Dicey]

Also, I'm confident the rates won't go up so much in ten years (it will definitely increase but not beyond 6%).

Bwa Ha Ha Ha!

Yup.  Seen that movie too.

Bet you read the book first.

[Another Reader]

Also, I'm confident the rates won't go up so much in ten years (it will definitely increase but not beyond 6%).

Bwa Ha Ha Ha!

Yup.  Seen that movie too.

Bet you read the book first.

I think we were around when it was written...

[magus]

Sam Dogen (financial samurai) has written about ARMs vs Fixed many times - nearly all of the last 40 years ARMs were the winner - and not even close - the overwhelming majority of ARMs have had rates drop after their initial term as interest rates have been largely straight down since 1981. About the only time it wasn't were people getting 1 and 3 year ARMs in 2003-2007, largely on LIAR loans that were interest only to start as well that reset to full amortization.

If you are getting a 5+ year ARM, especially with some reasonable reset terms, and can afford a higher payment if it happens, I think ARMs make sense for a lot of people, but it depends on the spread between fixed and the ARM as well. 50 bps or less, I prefer fixed. 75 bps is a toss up. 1% or more I will do the ARM all day every day. Some mortgage companies will even let you relock your ARM for the term amont for a fee of $295 at the prevailing rates. I originally got a 2.84% 5/1 ARM with Third Federal in Feb 2020 and paid $295 in early August 2021 to lower the rate to 2.00% for 60 months. Took a 3 minute phone call and one signed sheet of paper. The 30 year fixed rate at the time I did that was 3.75% - 1.75% lower now for 5 years will save me nearly $50k in interest in that time which I could use to pay down principal or invest elsewhere.

The single best reason I do not worry about rates rising too much is simply our federal government cannot afford it (a 4% rise in rates would add $14T+ to the national debt over 10 years), and therefore the Fed Reserve will continue to keep the FFR low and likely continue to buy Treasury and MBS paper.