Author Topic: Which Mortgage?  (Read 4409 times)

Rob

  • 5 O'Clock Shadow
  • *
  • Posts: 61
  • Age: 29
  • Location: Milwaukee, WI
Which Mortgage?
« on: July 21, 2013, 05:45:59 PM »
Some of you recently helped out in the thread I posted a couple weeks ago about my business partner and I buying our first property, a duplex, for 212k. We close in August.

We now are trying to decide what mortgage option will be best for us.

He has about $22k of capital and I have a little over $50k. Our take home after taxes and 5% to 401k's is about $2,750/mo a piece. Neither of us currently have any other big unusual monthly expenses. We will likely both be promoted within the next year to increase our take home to $3,400/mo, and both of our salaries are likely to continue to grow as we are just starting our careers.

We expect only minor up front costs with the duplex to rip out a bit of carpet and add a small wall, and our closing costs should only be about $1k. We would also like to add a bathroom to at least one unit, possibly both, which we do not have an estimate for yet.

We plan to hold the property for at least two years, living in it for one year, and then renting it. We expect rent to be at least $1350 per unit. While we live there, we will have a 3rd roommate in our unit paying ~$450, which will give us income of $1800/mo. We may hold long term, we just don't really know at this point.

They will pay water/electric and we will pay gas, which our high estimate is $200/mo on average. Taxes $500/mo.

If I am missing something, let me know. Here are the mortgages we are considering with estimates:

FHA

3.5% Down ($7420)

$204,580 (Base Loan Amount)
$3580 (FHA Up Front Fee)

$208,160 - Loan Amount

4.25% Rate

$1024.02 - Principal & Interest Payment
$234.18 - Monthly Mortgage Insurance

$1258.20 Payment (not including taxes and homeowners insurance)



Conventional


20% Down  ($42,400)

30 Year

$169,600 Loan Amount

4.625% Rate

$871.98 - Principal & Interest Payment
(~$227 principle, $644 interest in first two years)


15 Year

3.75% Rate

$1233.37 Principal & Interest Payment
(~$727 principle, $505 interest in first two years)

What do people think about an FHA? It would free up capital to add the bathroom right away, and possibly make another investment, but is it worth it?

Between the 15 year and 30 year, there is a difference of $361/mo, but we are getting $500 more each month in principle. Am I thinking of this wrong, or is a 15 year essentially giving us a 38% ROI verse a 30 year? (12k additional equity in 2 years for $8.66k additional payments.) I'm not sure I am thinking of this right.

What about ARMs? We didn't really look into them much, but if we sell in less than 5 years, would they be the best option?

Thank you for any help! The offer letter thread really helped us, so again, it is greatly, greatly appreciated.


fiveoclockshadow

  • Stubble
  • **
  • Posts: 216
  • Location: Baltimore
Re: Which Mortgage?
« Reply #1 on: July 22, 2013, 10:52:48 AM »
The PMI on the FHA is very expensive.  Also know that with FHA loans you can't stop the PMI early by paying down quickly any more - you'll have that $235 charge for a long time unless you refinance.

You should seriously consider a 5/1 ARM (or a Pen Fed 5/5 ARM).  Likely the interest rate will be lower than the 15 yr fixed while providing more liquidity.  Don't pay for interest rate protection you likely will never use.  You say you don't know how long you will hold it for - if there is a real possibility of holding for a very long time then maybe a fixed rate is OK but do the math first and see how much you will pay over say five to seven years for the option to hold it for the full thirty or fifteen at a fixed rate.  It may be rather costly compared to a 5/1 ARM.

willn

  • Stubble
  • **
  • Posts: 248
Re: Which Mortgage?
« Reply #2 on: July 22, 2013, 02:23:07 PM »
The PMI on the FHA is very expensive.  Also know that with FHA loans you can't stop the PMI early by paying down quickly any more - you'll have that $235 charge for a long time unless you refinance.

You should seriously consider a 5/1 ARM (or a Pen Fed 5/5 ARM).  Likely the interest rate will be lower than the 15 yr fixed while providing more liquidity.  Don't pay for interest rate protection you likely will never use.  You say you don't know how long you will hold it for - if there is a real possibility of holding for a very long time then maybe a fixed rate is OK but do the math first and see how much you will pay over say five to seven years for the option to hold it for the full thirty or fifteen at a fixed rate.  It may be rather costly compared to a 5/1 ARM.

Not a fan of ARMS.  Sure you plan on selling, but if you can't sell or change your mind...interest rates are near historic lows, even your 30 year loan is very, very low by historic standards.  Where do you think they'll go?

Lots of reasons you may not be able to sell in 5 years, too--what if your equity plummets and you owe more than its worth and can't come up with the difference?  What if the interest rate shoots up in year 5, your partner loses their job, and it takes 7 months to sell while you have to make the full payments that have now increased?   

Lots of real estate investors do this type of financing with ARMS, and lots of real estate investors get eaten alive and go bankrupt.  Find a guy whose been flipping, rehabbing, redeveloping, and landlording for 30 years, successfully, see how he does it.  If he's using an ARM, he's also got $5M in assets and he can write a check for it when it goes bad.

I haven't done too many deals, but I believe in two solid rules that mean you win:  1 - money is made at the buy, 2 - the deal needs to still work if bad shit happens.

Let's add a 3.  - Bad shit happens.

Another Reader

  • Walrus Stache
  • *******
  • Posts: 5109
Re: Which Mortgage?
« Reply #3 on: July 22, 2013, 03:12:14 PM »
Generally I agree about the ARM, except when the anticipated holding period is short and the spread is high - nearly two points here.  There is risk, but the benefits may outweigh the risk here.  An FHA is unnecessary and inappropriate for this scenario.  If there is a good chance they will hold for the life of the loan, then go for the long term fixed rate loan. 

The three points you make are well taken....

fiveoclockshadow

  • Stubble
  • **
  • Posts: 216
  • Location: Baltimore
Re: Which Mortgage?
« Reply #4 on: July 23, 2013, 04:20:05 AM »
Yes, potential for a long holding period is a risk for an ARM - but I think you overstate it because I don't think you understand the products being considered.

Take the Pen Fed 5/5 ARM.  Presently that is at 2.875% or almost two points below the fixed.  It can only adjust by 2% every five years and the maximum it can adjust by over the life of the loan is 5%.

So, let's assume interest rates shoot through the roof.  We are two points below the 30 yr fixed for the first five years, then we are at the same rate as the 30 yr fixed for the next five years, then we are two points above the thirty year fixed for the next five years after that.  So we save a lot of money in the first five, we actually still save a bit of money in the second five years because we have a lower loan balance than in the case of the 30 yr (more favorable amortization), and finally in years 10-15 we are now paying more in monthly payments than the 30 yr but in total we will have paid less than the 30yr over the first fifteen years of the loan.

So I stand by my recommendation - strongly.  The 5/5 will cost less than the 30 yr fixed over at least a 15 year holding period.

This is a common misunderstanding about ARMs.  Everyone thinks of 1/1 ARMs with super low introductory rates and early payment penalties.  Yeah, those are bad.  But blindly buying 30 yr fixed mortgages on properties rarely held anywhere close to 30 years is also risking flushing money down the toilet.  Always do the math.  Remember, mortgages usually cost as much as the house and at higher interest rates even more than the house.  Everyone obsesses over negotiating on the house price - why wouldn't you spend a lot of time evaluating the cost of the mortgage?  And one of the biggest costs in a mortgage is interest rate protection.  Don't buy more house than you need and don't buy more interest rate protection than you need.

Oh - and of course there is never one correct answer.  ARM vs. fixed not only depends on the holding period of the buyer but it also depends a whole lot on the yield curve.  For example, about a decade ago 10/1 ARMs were good alternatives to 30 yr fixed but these days they make little sense and are rarely offered as their rates are nearly the same as a 30 yr.

willn

  • Stubble
  • **
  • Posts: 248
Re: Which Mortgage?
« Reply #5 on: July 23, 2013, 09:49:39 AM »
Yes, potential for a long holding period is a risk for an ARM - but I think you overstate it because I don't think you understand the products being considered.

Yes thank you, I stand corrected.  I personally wouldn't borrow to buy rental so I'm not tuned into the details of many loan products.

Rust

  • 5 O'Clock Shadow
  • *
  • Posts: 87
Re: Which Mortgage?
« Reply #6 on: July 23, 2013, 10:58:21 AM »
To step away from the ARM talk and back to the original three options.

The monthly payment difference between the options are the following: (Based off the FHA)

FHA: 1,258
30: 872 ($386)
15: 1233 ($25)

Cash outlay (or sometimes called downpayment)
FHA: $11,000
30: $42,400
15: $42,400

Break even in months from a payment amount perspective but only on the 30 to FHA.  Because if you want to do the 15 the FHA doesn't really make any sense.  Why pay the PMI when you can just pay principal.

42,500-11,000 = 31,500/386 = 81 Months or 6 years 9 months.

Without taking into account investing the difference ($31,500) into a different investment, if you own the property for more than 6 years 9 months, you should select the 30 year option rather than the FHA. 

*This is assuming the PMI doesn't drop off, Didn't take the time to figure out when PMI would drop due to equity but to be conservative lets assume it's still there*

Now for choices.

I'd take the FHA and reinvest the balance in another investment property.  But that is me.  I'm not afraid of leverage.


Rob

  • 5 O'Clock Shadow
  • *
  • Posts: 61
  • Age: 29
  • Location: Milwaukee, WI
Re: Which Mortgage?
« Reply #7 on: July 23, 2013, 06:32:24 PM »
Yes, potential for a long holding period is a risk for an ARM - but I think you overstate it because I don't think you understand the products being considered.

Take the Pen Fed 5/5 ARM.  Presently that is at 2.875% or almost two points below the fixed.  It can only adjust by 2% every five years and the maximum it can adjust by over the life of the loan is 5%.

So, let's assume interest rates shoot through the roof.  We are two points below the 30 yr fixed for the first five years, then we are at the same rate as the 30 yr fixed for the next five years, then we are two points above the thirty year fixed for the next five years after that.  So we save a lot of money in the first five, we actually still save a bit of money in the second five years because we have a lower loan balance than in the case of the 30 yr (more favorable amortization), and finally in years 10-15 we are now paying more in monthly payments than the 30 yr but in total we will have paid less than the 30yr over the first fifteen years of the loan.

So I stand by my recommendation - strongly.  The 5/5 will cost less than the 30 yr fixed over at least a 15 year holding period.

This is a common misunderstanding about ARMs.  Everyone thinks of 1/1 ARMs with super low introductory rates and early payment penalties.  Yeah, those are bad.  But blindly buying 30 yr fixed mortgages on properties rarely held anywhere close to 30 years is also risking flushing money down the toilet.  Always do the math.  Remember, mortgages usually cost as much as the house and at higher interest rates even more than the house.  Everyone obsesses over negotiating on the house price - why wouldn't you spend a lot of time evaluating the cost of the mortgage?  And one of the biggest costs in a mortgage is interest rate protection.  Don't buy more house than you need and don't buy more interest rate protection than you need.

Oh - and of course there is never one correct answer.  ARM vs. fixed not only depends on the holding period of the buyer but it also depends a whole lot on the yield curve.  For example, about a decade ago 10/1 ARMs were good alternatives to 30 yr fixed but these days they make little sense and are rarely offered as their rates are nearly the same as a 30 yr.

Thank you all for the replies.

Is the Pen Fed 5/5 ARM too late at this point in the offer to do? We already have an accepted offer and have to close in August and have not tried to get approved for financing at Pen Fed.

It seems there are a variety of differing opinions here. If we can get the Pen Fed, that seems like it may be the best option. The problem we have with the FHA is that while we would love to have more money to invest, we don't think we want to invest in another property in Milwaukee, we would be looking most likely at foreclosures in Chicago that would likely require more than ~35k investment.

I am pretty good at math, I am just not sure how to weigh the differences here because I don't know how to value equity vs. cash, and I am unsure of the holding period. Should they be valued equally? Are there any good mortgage comparison calculators out there?

It seems the four options would be:
Conventional 30 year: ~4.69% APR
Conventional 15 year: ~3.75% APR
FHA 30 year: ~4.4% APR
PenFed 5/5 ARM: ~3.25 ARM

Thanks again.

fiveoclockshadow

  • Stubble
  • **
  • Posts: 216
  • Location: Baltimore
Re: Which Mortgage?
« Reply #8 on: July 24, 2013, 08:13:59 AM »
Hi Rob,

So most of the paper work involved in getting a mortgage approved is dependent on the property purchased and a "pre-approval" often only helps things go a little bit more quickly.  If you are interested in the Pen Fed I'd give them a call and explain your closing date and see what they think the timeline is.  With that information you can decide if they are an option still on the table or not.

As to deciding which of the various options is best for you that is an extremely complicated question.  You are always dealing in unknowns and an unknown holding period is a big one.  The other big unknown is the value of liquidity which is the primary trade off in a 15 yr mortgage (i.e. 15 yr gets you lower rate but you will have less liquidity over time as more money is locked in equity in the house).

I can recommend this site:

http://www.mtgprofessor.com/

as an excellent overview of all the trade offs in mortgages.

Lastly, I think it is also important to realize we are at rates that are still historically incredibly low.  So don't beat yourself up unnecessarily.  I know I was the one that brought up the ARMs as an option, and you should consider them, but right now you've got a deal on the table and the clock is running to close.  So spend a day or two to make your decision and then get moving on it - falling out of or needing to extend escrow is something to avoid.  Even if you end up not making the perfectly optimal choice on the mortgage you will still be getting an excellent rate.  Analysis paralysis can be a real problem sometimes!

Gerard

  • Handlebar Stache
  • *****
  • Posts: 1402
  • Location: eastern canada
Re: Which Mortgage?
« Reply #9 on: July 24, 2013, 02:39:46 PM »
It seems the four options would be:
Conventional 30 year: ~4.69% APR
Conventional 15 year: ~3.75% APR
FHA 30 year: ~4.4% APR
PenFed 5/5 ARM: ~3.25 ARM

I apologize for being Canadian and maybe missing some issues specific to your situation, but in my market I would prefer the conventional 15 year out of these options, on the math. The 15 year gives you a 1% bonus over the 30, while costing you only 0.5% to avoid the risk of increased rates in 5 years (you'd need the expected increase at the 5 and 10 year mark to be less than about 0.55% for the PenFed deal to be better).

Any lender's website should let you plug your numbers into a calculator and generate amortization tables (I'd be a sweetie and do it for you, but Canadian calculators mostly won't calculate a term longer than 25 years!). Then I'd compare where I'd be with each option at the end of 1, 2, 3... years, think hard about the most likely length of time that I'd own the place, and go from there.