Q. My husband and I have a mortgage balance of $417,000 with a rate of 4.75 percent on an interest-only 10/1 ARM. We have been offered a 30-year fixed-rate loan of 3.875 percent with no closing costs and another 10/1 interest-only ARM at 3.50 percent, again with no fees.
My guess is we probably won’t be in the house for 10 years, but it’s possible. Should we grab the 30-year fixed because rates are so low, or should we be greedy and take another 10/1 ARM?
I vote for the 30-year fixed, but my husband wants the ARM.
A. First, as of this writing, those rates are very good if they truly come with zero closing costs. And if you have great credit and lots of equity, I can see that those rates would, indeed, be available with no fees.
The simple way to determine whether the 10/1 ARM is better than the 30-year fixed is to run the numbers. So let’s do it.
For those folks who are unfamiliar with these products, a 30-year fixed-rate loan carries a fixed rate and a fixed monthly principal-and-interest (P&I) payment over the 30-year period. A 10/1 ARM allows the payment to cover only interest (there’s no principal curtailment) for the first 10 years. After that, the interest rate can adjust annually and the loan will amortize over the remaining 20 years.
The P&I payment on the 30-year loan is $1,961 per month. The interest-only payment on the 10/1 ARM is $1,216 — a difference of $745 per month. Over 10 years, the borrower saves $89,400 in the reduced payment on the 10/1 ARM. But the balance at the end of 10 years remains at $417,000 because none of the principal was paid down.
Under the amortized 30-year loan, the balance of the loan at the end of 10 years would be $327,134. This is a drop in principal balance of $89,866, just $466 more than the payment savings that the 10/1 interest-only ARM offers.
So there’s no relevant difference in the first 10 years between these two products unless you manage, or mismanage, the $745 monthly savings on the 10/1 ARM.
Now it boils down to discipline. Ask yourself this question: “Are we likely to wisely invest the $745 saved each month on the 10/1 ARM?” If so, the sum at the end of 10 years will be a lot more than the $89,866 in equity that automatically was built up under the 30-year, fixed-rate program. If you are likely to squander the $745 difference and have nothing to show for it 10 years later, you will be less wealthy, to the tune of $89,866.
The last thing to consider is the likelihood of your holding the loan for more than 10 years. If rates don’t fall and there’s no refinance opportunity, you might want to grab the fixed rate as an insurance policy in case rates are way up 10 years from now.
There’s never a right or wrong answer. The “right” answer depends upon your risk tolerance, fiscal discipline and cash-flow requirements.
Henry Savage is president of PMC Mortgage in Alexandria. Send email to henrysavage@pmcmortgage.com.
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