What type of mortgage is the best to get right now?

[The Sauce]

I am buying a home (thats for everyone who has helped before). I was considering getting 5:1 or 7:1 ARM but I am not sure that this is a good idea with the likelihood of interest rates rising in the next couple of years. However I think there is a pretty good chance that I will be able to have the mortgage paid off within 7 years. Is this a terrible idea?

 

[FeathersMcGraw]

If you plan to pay off your loan in 7 years, an ARM will probably save you money with initially lower interest rates; just be sure to check the adjustment cap (how much your rates can rise within a certain period of time) and the adjustment period (how often it can change). Also be sure to verify your loan doesn't carry any sort of prepayment penalties.

I have no idea what your financial situation is, but I'd be wary of trying to pay off a mortgage too quickly, particularly if you haven't done things like begun retirement savings. I'd rather have cash on hand for emergencies and invest somewhere that will exceed the rate of (very low) interest rates, while still getting a very nice tax deduction on the mortgage interest.

 

[The Sauce]

Thanks for the input. But really, where can you invest money that will exceed the interest rate of a mortgage aside from the stock market? Even at todays low rates a fixed motgage will weigh in at about >5%. The average return rate of the major indexes is like 7%. Everything else less aggressive is considerably lower than that...and there's a lot of risk in investing in the stock market as opposed to in your home. Don't you think?

 

[wyvrn]

The historical average return for the large stocks is 13%. But you have to hold them awhile so the ups and downs smooth out over time. Where did you get the 7% figure?

We are studying historical returns in my finance class right now. The risk free proxy, treasury bills, is just over 4%. Govt. bonds some in slightly higher (have higher risk premium), then corporate bonds, then large stocks, then small company stocks (where historical return is close to 17%). Of course these historical averages are over the last 50 years.

If you want a higher return, you have to take risk because the diff in the risk free rate (treasury bills) and actual return is risk premium for holding that investment. And you gotta be willing to hold them long term. Since you are comparing this to a mortgage, which is a long term investment, I assume you have a long time horizon of say 15 years or so. In that case, you might benefit by putting some money into a spider fund or the S&P500 index. Just look for a fund with low fees.

edit: since we are on the discussion of finances, I would also strongly suggest having several months worth of liquid assets on hand in case of emergencies. You can put it in an Ingdirect account and get 2% or buy short term govt securities and get closer to 4%, which just about keeps up with inflation.

Really what you need to do is sit down with pen and paper (or MS Excel) and figure out what your 5 year, 10 year, and retirement-year goals are financially. Only when you know that can you make reasonable decisions regarding where to put your money.

edit2: Good article on fatwallet forums about ARMs vs FRMs.

 

[Hayabusa Rider]

I think it would be foolish to get an ARM right now. If you really can pay the mortgage off in 7 years, thats great. The total amount of interest you would pay between an ARM and fixed rate is not great. What happens if rates climb? They can't go down much, but they certainly go up. That would mean you either having to pay more per month or take longer to pay it off. Also you PLAN to pay it off. What happens if that doesnt work out? You will have to accept the probability of higher rates then. ARMs are nice when interest rates are high, but look to be going down. Otherwise IMO it's unjustified risk

 

[PlatinumGold]

Originally posted by: Snatchface
Thanks for the input. But really, where can you invest money that will exceed the interest rate of a mortgage aside from the stock market? Even at todays low rates a fixed motgage will weigh in at about >5%. The average return rate of the major indexes is like 7%. Everything else less aggressive is considerably lower than that...and there's a lot of risk in investing in the stock market as opposed to in your home. Don't you think?

here's the thing, whether you pay your home off early or not, the amount of appreciation is the same, so that should not be a consideration when making investments.

if i bought a home with 20k down and made payments for 7 yrs, during that 7 yrs period lets say i only put about 10k into equity of the home. my net gain will be determined primarily by appreciation, not by equity i put into it.

so really interest is your primary expense.

i'd suggest not paying off your home so early, getting a long term loan if you know that it is a home you will live in for 20+ years.

if you plan on selling the home within 7 yrs than go for the arm of course.

btw, i gained 15% on my mutual funds over the last 7 months. i can live with that type of return.

 

[Leejai]

One thing to note, it's not only if you're planning to pay off the loan in 7 years, but also if you plan on living in that house for 30 years. US average is 7-8 years. Also, it's pretty tough to say you won't refi w/in 30 years to let's say do improvements on the house, etc.....

If you're in it w/ a family...remember this....once the kids are all grown up, you won't need such a big house...so will you have it in 30 years?...

 

[The Sauce]

All good advice, thanks a lot.

 

[FeathersMcGraw]

Originally posted by: Snatchface
Thanks for the input. But really, where can you invest money that will exceed the interest rate of a mortgage aside from the stock market? Even at todays low rates a fixed motgage will weigh in at about >5%. The average return rate of the major indexes is like 7%. Everything else less aggressive is considerably lower than that...and there's a lot of risk in investing in the stock market as opposed to in your home. Don't you think?

I'm not entirely convinced that investing in a home is less "risky" than the stock market, simply because there's an opportunity cost to tying up all of your money in a house instead of investing the money elsewhere. That 7% figure you cite for the stock market is a fairly conservative one, particularly when you start looking at timeframes on the order of a decade or more -- and that's precisely how you mitigate the risk of investing in the stock market: by making sure you invest for the long term, and not trying to jump on board when the indices post a week of gains or sell when the market takes a dive.

The real question is whether you expect the price on your home to appreciate faster than equivalent investment in the stock market. Building equity is fine, but if you want to extract some of that money you need to tap it either by using a home equity loan or line of credit (and given your aggressive plans to pay off your mortgage, you seem loan-averse) or by selling your home (which has its own drawbacks). Home equity is a wonderful asset, but not a particularly liquid one.

Ultimately, you shouldn't really invest money that you expect to need in the short-term. I'm not saying owning your house free and clear is a bad thing, but be sure that you don't wind up in the situation where your only asset is a house and you have no savings for emergencies or have to assume debt to put things in it.