What does MM think of this?

hoffse · February 2014

Hi everybody,

As I've mentioned before, H and I are looking to buy a house in the next year or so. I also just started a new job with a significant raise, and last week I got my first paycheck. So H and I talked over various options in terms of timing with our housing goals and also various mortgage options. We've decided to keep the same timeline so that we can put down 20%.

So I still have a year. I've started looking at various mortgage options just to begin educating myself on that side of things, and I came across a really interesting one through PenFed. We just used PenFed to finance our car, and they were great. This mortgage package has been around since at least 2011, so hopefully it will still be available a year from now. I'm wondering what MM thinks about it though. The highlights:

-5/5 ARM - Starts at 2.75% (current rates - this will probably change a bit) and then adjusts once every 5 years.

-Maximum increase/decrease is 2% every 5 years

-Total maximum increase over the life of the loan is 5%

-PenFed pays most of the closing costs (including inspections and recording fees). Buyer is responsible for title insurance, proof of home insurance, and any taxes due for the year (totally reasonable IMO). There is no loan origination fee. You do have to reimburse PenFed for the closing costs if you keep the house for less than 36 months. But I don't see us doing that.

-No PMI if you put down 20%

So two other things about this. First, and this is a big one, at the end of our first 5-year term, I would be up for partner starting in year 6 of the mortgage. My H would be up for partner starting year 7 or year 8 of the mortgage. So there's a strong likelihood that our income is going to go up a lot sometime during the second 5-year term.

Second, assuming the worst case scenario here - which means a 2% increase every 5 years - the break-even point compared to PenFed's 30 year rates is around year 13/14. Obviously that changes a bit each month depending on what current rates are, but that's where it is right now. So if we sold the house before the break-even point, we would spend less on interest with the 5/5 than we would with a 30-year fixed.

What does MM think of this idea? On the one hand, I know that a lot of people get burned by ARMs. On the other hand, it seems like it might be a really good fit for our situation, especially since our income is probably going to change a lot in 5-7 years.

TIA

formerlyGDaisy09 · February 2014

We have a similar loan through our bank called a 5/1 arm loan. the interest rate is fixed at 3.25% for the first 10 years after that the interest rate varies yearly, but it can never change more than 1% a year, and can never change more than 5% from the original interest rate (so it can never be higher than 8.25%, remember before the housing bubble an 11-15% interest rate on a mortgage was common). The bank covered $5000 of our closing costs, and like a lot of people do the sellers covered anything over that.

We might decide to refinance before we hit that variable rate period, if we get closing costs together. and like I've mentioned in previous posts we purchased this home as a starter, with some room for renovations so we could grow in it a little, but ultimately we're not planning to stay in it much beyond the 10 year mark, that was one of the biggest reasons we thought that the 5/1 arm loan was right for us.

cbee817 · February 2014

I prefer to keep things as simple as possible when it comes to loans. We refinanced in 2010 to a 15 year fixed at 4.00% from a 30 year at 5.375% (bought the house in 2007) because our income went up a decent amount. I like knowing what my payments are every month with a few dollars difference up or down when they update the escrow account once a year. Going to a 15 year is huge for us- in 2025, we'll be in our early 40's with 2 girls approaching college age and not have a mortgage payment.

vlagrl29 · February 2014

cbee817 said:

I prefer to keep things as simple as possible when it comes to loans. We refinanced in 2010 to a 15 year fixed at 4.00% from a 30 year at 5.375% (bought the house in 2007) because our income went up a decent amount. I like knowing what my payments are every month with a few dollars difference up or down when they update the escrow account once a year. Going to a 15 year is huge for us- in 2025, we'll be in our mid-40's with 2 girls approaching college age and not have a mortgage payment.

This is me. I like knowing exactly how much things will cost and I like fixed interest rates.

Xstatic3333 · February 2014

I'm with PPs as it comes to us, but that said, given that you and your H are high income earners who live well below your means, I could see that loan being a great fit for YOU.

maple2 · February 2014

I do think that despite the bad press about ARMs, they can be a smart financial choice for some people. For me, it would come down to which option would have the highest probability of providing the best financial outcome. What is your plan around the (worst case scenario) break-even point? Would you be selling before then? Would your increased income allow you to pay the mortgage off in full before then if you didn't sell? If it was me and neither of those was a likely outcome I would probably pass on the ARM because of the potential for it to cost more than the fixed rate option. I know there might be the possibility of refinancing between now and then, but with the uncertainty about interest rates over that time frame and the cost associated with a refinance I wouldn't want to take that chance and end up paying more over the life of the loan.

KatieCutie05 · February 2014

ARM carry more risk then fixed rate because if the higher rate causes you to not be able to afford your mortgage then you may risk losing the house or missing payments. I've never heard of he rate on an ARM going down... Although I've never had one. But I know how much of a difference even 1% makes on say a 200k loan.... That's 165 dollars per month.... So 2% would be an extra 330 dollars a month. Idk about you but that's a lot of money to throw away just for the fun of it. I'd rather pay 4% for 30 years or better yet 3% for 15 years and carry less risk. Annual raises just aren't a guarantee and even seemingly secure jobs are not that secure. Trust me I've seen it one too many times. So I'd never rely on that to be able to pay my mortgage. Its just too risky.

Wulfgar · February 2014

Since this will most likely be just a starter home for you, I would say what you are doing will work fine. Also, if you make extra payments towards your mortgage you could pay it off prior to the 13/14 year break even point.

If you are planning on buying a home that will work when/ if you have children then take this deal and pay the house off in 10 years since both of your incomes will be going up in the 6 to 8 year period of the mortgage.

hoffse · February 2014

^^ My parents actually had an ARM with their first house that went down every single year after the fixed period until they re-financed out of it. That happens when you enter into an ARM right before interest rates collapse. That's not likely for us since interest rates ought to be going up over the next 5-10 years.

It's still pretty compelling to me because our "grand plan" is to sell in 10-ish years after buying. So we wouldn't hit the break-even point. Of course, that's us just talking. Things could certainly change down the road. That said, we could afford it at the highest interest rate now (7.75%), it just would be nicer to pay less. So I guess the adjustment factor doesn't really bother me other than wanting to sell or re-fi before the break-even point. But it's more a mathematical thing than an "oh god we have to do it or we will lose the house" thing.

I guess I'm wondering if there's anything about ARMs that make them unpopular, other than the adjustments? I do have a sense that one reason people get burned by them is because they either don't know what they're getting into, or they are borrowing at the limits of their income starting with the entry-level interest rate. It seems like a monumentally bad idea to enter into an ARM if you can't afford the mortgage at the highest possible interest rate the day you sign on the dotted line. But I guess a lot of people do that?

The closing costs are also enticing. Paying a 1-2% origination fee on a loan has no purpose whatsoever except to make more money for the bank. Interest rates I understand because they are somewhat related to risk. Origination fees get tacked on at the very end when you've fallen in love with the house and can't imagine walking away. So those bother me on a very fundamental level. The 30-year fixed options do have origination fees and don't cover other closing costs, so there's an added savings there that I haven't calculated in all this.

Well it's interesting to hear various perspectives. H and I have a long time to think about it, but I am extremely intrigued.

smerka · February 2014

I am one of the senior posters here as far as age goes. I think you are assuming you will be at your current job in 15 years. When I was 25, I thought I'd be in the industry I was in for my entire working life. I planned to maybe have kids but keep working. Fast forward 15 years. I got totally burnt out and by the time I left to become a SAHM, I hated it. Now that I'm a SAHM, there is no way I could handle working and being a mom. It would be too much stress for me. I know other women do it, and do it well, but I am not that woman. Also your husband hasn't even become a lawyer yet. There is no guarantee he will like it. I know you have talked about having kids. There are no guarantees you won't have a child with special needs. I'd hate to see you trapped in an adjustable mortgage (with all indicators pointing to interest rates rising) and faced with the decision of having to quit working to care for a child. I would choose the comfort of knowing my mortgage payment won't go up over the possible interest savings.

vlagrl29 · February 2014

smerka said:

I am one of the senior posters here as far as age goes. I think you are assuming you will be at your current job in 15 years. When I was 25, I thought I'd be in the industry I was in for my entire working life. I planned to maybe have kids but keep working. Fast forward 15 years. I got totally burnt out and by the time I left to become a SAHM, I hated it. Now that I'm a SAHM, there is no way I could handle working and being a mom. It would be too much stress for me. I know other women do it, and do it well, but I am not that woman. Also your husband hasn't even become a lawyer yet. There is no guarantee he will like it. I know you have talked about having kids. There are no guarantees you won't have a child with special needs. I'd hate to see you trapped in an adjustable mortgage (with all indicators pointing to interest rates rising) and faced with the decision of having to quit working to care for a child. I would choose the comfort of knowing my mortgage payment won't go up over the possible interest savings.

THis is a great point and I can totally relate. I'm not one of those that can work full time and care for a child as well. I know tons of people do it, but it's definitely not for me.

hoffse · February 2014

My husband worked for a massive firm for two years before going to law school (hence the reason we weren't in the same class). He's very aware of what the job is going to be like. He bailed associates out all the time when partners got pissed at them. He's also watched me practice for two years, and his a dad and godfather are both lawyers. He grew up around it. I don't think there are going to be too many surprises there.

I know that my goals might change, but I'm certainly going to give working a shot after we have kids. Frankly, I would need to have quintuplets before it made any financial sense for me to stop working, and I really do love my job. I've honestly never considered becoming a SAHM, because I don't think I have the temperment for it (my H heartily agrees with that). Obviously all that can change, but I don't think it will change for at least a few more years. Law isn't nearly as bad as everybody told me it was going to be.

Anyway, we will consider all of this. Most of the houses we are looking at are affordable on one income if that became necessary. We wouldn't be putting much away into general savings, but we could maintain our current lifestyle and retirement contributions. So we would manage just fine.

vlagrl29 · February 2014

hoffse said:

My husband worked for a massive firm for two years before going to law school (hence the reason we weren't in the same class). He's very aware of what the job is going to be like. He bailed associates out all the time when partners got pissed at them. He's also watched me practice for two years, and his a dad and godfather are both lawyers. He grew up around it. I don't think there are going to be too many surprises there.

I know that my goals might change, but I'm certainly going to give working a shot after we have kids. Frankly, I would need to have quintuplets before it made any financial sense for me to stop working, and I really do love my job. I've honestly never considered becoming a SAHM, because I don't think I have the temperment for it (my H heartily agrees with that). Obviously all that can change, but I don't think it will change for at least a few more years. Law isn't nearly as bad as everybody told me it was going to be.

Anyway, we will consider all of this. Most of the houses we are looking at are affordable on one income if that became necessary. We wouldn't be putting much away into general savings, but we could maintain our current lifestyle and retirement contributions. So we would manage just fine.

You know yourself best. I've always known I've wanted to stay home with my kids, but dang there are some days that I just want to check out!

brij2006 · February 2014

I honestly would look for a conventional 15 year fixed rate mortgage and put your 20% down. Pretty much all mortgages don't require PMI if you put 20% down. You can also always negotiate that seller pays part of closing costs.
I would assume that what the loan will cover in closing costs won't be more than the difference in what you will pay in interest over 25 years if the rates go up 5%.
Also I'm going to agree with PP that your lives may change a lot between now and then. We only wanted to stay in our house 5 years and I never wanted to SAH. 5 years later, we don't see us leaving our house and I would love to have the option to SAH. Even if I don't do it full time.

maple2 · February 2014

My sense (based purely on anecdotal evidence) is that people who ran into trouble with ARMs did so because the future didn't play out the way they anticipated and they weren't financially prepared for the consequences. For example, people who purchased a home with an ARM and fully expected to sell at a profit before the highest interest rates set in. The housing market tanked and they couldn't sell their houses. Since they never expected to be there when the interest rates went up they weren't prepared to make payments at that level. They weren't necessarily stupid or uneducated, they just didn't take into account that things in the future could be really different than they were expecting based on current conditions. That seems to be the cautionary message of several pps, though they put it in the context of changes in personal/professional priorities rather than the housing market.

Either way you go there is going to be some risk. If you go with the ARM, there is a chance things won't work out the way you expect (you want to SAH, one of you decides to opt out of the Big Law lifestyle, the housing market does something crazy again, you decide you love your starter home so much you never want to move, etc.) and you will be on the hook for making large monthly mortgage payments and paying more money over the life of your loan. If you go with the traditional loan, life may go exactly as you expect and you risk paying more interest on your loan than you would have otherwise.

It sounds like you would be comfortable with the worst case scenario in either instance, so there isn't an option that clearly has to be excluded because it could produce a catastrophic outcome. I would make the decision based on my assessment of the likelihood of various future scenarios and tradeoffs between those risks and the financial rewards of the different loan options. If you were able to sell you house at year 10, how much would you have saved relative to a conventional loan for that length? Would that amount of savings be worth the risk (however high you perceive it to be) that you life might go very differently than you currently expect and you might get stuck in a less ideal situation? If its not a lot of savings, then I would probably go with conventional. If I wasn't sure whether it would be year 10, 11, 12, or 13 that we sold (going right up to the break even point), I would probably go with conventional because the benefits of the ARM decrease but the risks remain the same.

JuneMrs · February 2014

We went with a 30 year loan and pay double principal on the loan to pay it off more quickly that was what worked best for us.

MommyLiberty5013 · February 2014

I understand that you and DH are in the legal field and that making partner is on your horizons...but you aren't partners yet, a lot can happen in 5-8 years. A lot. I would not get involved in an ARM banking on making partner. You probably will both be partners, but what if you get sick, have an accident, have triplets, one decides to be a stay-at-home-parent, one of you dies, or the economy crashes again and your firms downsize instead of making you partners?

I personally feel that it's best to make large financial decisions, involving debt using the current or 1-2 year projected incomes, not incomes half to a full decade later. It seems like counting one's chickens before they are hatched.

Sisugal · February 2014

Are there fees/charges/penalties for an early termination of the loan balance or monthly prepayments?

JoanE2012 · February 2014

I would only choose this ARM option if you were comfortable paying the max percentage today. Don't count on what you're expecting in the future.

On a related note, it was important for us to be able to afford the monthly payment on only one salary. Mostly because we didn't want to be house poor and we love to travel.....but also in case something happens to either one of us and we lose a salary. You never know what the future brings. Being prepared for the worst today (including max interest rate) is important.

hoffse · February 2014

Sisugal, no there are no fees/charges/penalties, etc. for paying the mortgage off early.

We are comfortable paying the max amount today - it would actually cost less than our rent given the kinds of houses we are looking at - and I think with the savings on closing costs and the break-even point being past the time we would expect to stay in the house it could be a pretty good product for us.

We won't be able to afford it on one income until our student loans are gone. But we will be turning to those in short order. Frankly, those will cost us WAY more per month than the mortgage would. Like... twice as much as the mortgage. But we have a 5-year plan to take care of those. After that, we could absolutely afford the house on one income.

I feel pretty good about it TBH. We could afford the max interest rate now. And we would be at least 20 years away from the max interest rate being a possibility (because a 5/5 adjusts every 5 years, not every year). I have to imagine we would have long sold the house by then. I was going to have to work until our student loans were paid off anyway (my H's enter repayment in November). The house doesn't really affect that to a large degree, since it would actually save us money over our current rent - and the 5/5 would save us a LOT of money in the first five years (from interest) while we're trying to get the student loans knocked out. That's an extra $400/month or so that we can send to student loans. It makes a 5-year snowball not just feasible, but actually pretty easy.

I definitely see why it wouldn't work for everybody. But I think for us it could be pretty good. The whole max interest rate thing just doesn't give me heartburn.

What does MM think of this?

Re: What does MM think of this?

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