Posted in Liabilities and Debt

Don’t twist your ARM, fix it !!!

Refinancing an existing mortgage is a major decision and there are many factors that you take into account, to ensure that you benefit in the long term.

I recently refinanced my mortgage from a 30 year 7/1 ARM to a 30 year fixed rate.

One of the straightforward reasons of refinancing is when you are on a fixed rate and you can refinance to move to a lower fixed rate.

The simple calculation is take the total of closing costs and any points you have to pay, and divide it by the monthly savings in payment. That would give you the time in which you will recoup the closing costs and points.

N = (C + P) / (OP – NP)

N = the number of months for which you must keep the mortgage or the home for the refinance to make sense.

C = total closing costs as provided by the lender’s disclosure statement

P = Points you may additionally pay to lower the rate further. Sometimes this may be included in C already.

OP = Old Payment, NP = New Payment [Use the calculator at bankrate.com]

Easy, right? The above formula also helps in figuring out how many points you should pay to lower your rate. Note that P and NP will vary accordingly.

But there are many people who are on an Adjustable Rate Mortgage (ARM) where either the rate already floats with market or will float after a fixed period.

adult arm fashion hand
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Typically ARM mortgage rate during the fixed period (7 years for a 7/1 ARM)  is lower than a 30 year fixed rate mortgage. But the interest rate risk is completely passed on to you in future.

Hence as the interest rates dip in the market, it may be wise according to one’s situation to refinance to a 30 year fixed.

I vacillated with this decision for a long time as I had a 3.625% 7/1 ARM since last one year. However since then the interest rates started ticking upwards and as the periodic dips came in, I was looking for an opportunity to move to a fixed rate.

But getting a 3.625% or lower fixed rate is not possible today. So I had to refinance to a 4.125% fixed rate. This is counter intuitive to the logic and calculation given above for a fixed->fixed refinance. How does one even justify a slightly higher payment and larger interest component post a refinance?

Here are the factors I considered. This is according to my financial situation and long term goals. Your situation may require to hold the ARM with no problems.

  • I want to keep the house for long term. This is the most important factor.
  • To save the uncertainty of interest rate risks in 7 years, initially my strategy was to pay off the mortgage as much as possible in the first 7 years and then refinance at the prevailing rates for the remaining balance.
  • To do above, I had to make substantial extra payments towards the mortgage, which skewed my asset allocation (see my earlier post on this: The Paid Piper of Hamelin) more towards Home Equity or Real Estate.
  • On the other hand, the fixed mortgage (and hence fixed payments) will give me the peace of mind and flexibility to invest more in other assets (instead of throwing extra money to the mortgage).
    • There is no risk of interest rates (and payments) going higher in the 8th year.

But how does the math add up? It is not as straightforward as the previous formula.

Lets take the following mortgage and refinance decision.

  • Starting balance – $100,000
  • Acquired at 7/1 ARM 3.625% ARM (lifetime cap at 8.625%)
  • After one year, refinance to 4.125% fixed for 30 years

Lets run the numbers in two scenarios. You can read my post on The Paid Piper of Hamelin to determine which below scenario/strategy will apply to you.

If I keep paying extra I can payoff the mortgage in about 11 years.

You can use the mortgage calculator at bankrate.com to calculate the total interest paid in both cases.

  • In the 7/1 ARM, I assumed the 3.625% in the first 7 years during which majority of the principal is paid off. For simplicity, the rate is assumed to be fixed till the mortgage is completely paid off in about 11 years.
  • In the fixed rate, the calculation is done with 4.125% on the current balance and assuming same extra payments per month.

Original principal on the 7/1 ARM at 3.625%.  – Extra payment of $465/mo, which is same as the monthly payment (thus effectively paying double).

Refinance-3

After one year of payoff on the 7/1 ARM, the balance will be $92000 and the interest paid will be $3500. Now lets say the balance is refinanced at 4.125% and the extra prepayment per month is kept steady.

Refinance-payoff-2

Since the 7/1 ARM was paid off quite a bit, the cost of remaining balance at 4.125% actually comes pretty close. If you add the interest already paid on the 7/1 ARM, then definitely the fixed rate is costlier ($25000 vs. $21369) simply due to the higher rate and the added refinance costs. However the above 7/1 ARM case also assumes that the rate does not increase at all between 8-12 years. So in reality, the savings of 7/1 ARM may cancel out in favor of the fixed rate, if the rate moves up steadily. 

Now what if I don’t pay extra and invest the rest?

This is tricky calculation but for the 7/1 ARM if I assume the interest rate will touch the maximum (8.625%), then the overall interest paid over 15, 20 and 30 years will be much more (nearly double) than the fixed rate mortgage.

Even with the slightly higher monthly payment, if I invest the extra money according to asset allocation, I should come out better over the long term. Lets run the numbers again.

In case of the fixed rate, the total interest payment in 30 years will be in the range of $72983. Lets add the refinancing costs of $4500 and interest already paid in first year of 7/1 ARM- $3500. 

  • Note that the balance after maintaining the 7/1 ARM for one year, without paying any extra is $98000. 

Total cost for fixed rate 4.125% = $72,983 + $3500 + $4500 = $80,983

Refinace-fixed-30yrs-nopayoff

Now assuming the full risk of the ARM (no refinancing), the calculation comes out to be (done in two steps):

  • First 7 years, total interest paid = $23,611 and balance = $85000

Refinance-4

  • For next 23 years, since the spread is 3.625%-8.625%, we take the median 6.125% and calculate the total interest to be paid on the balance $85,302.91 in 23 years.

Refinance-5

Total cost for the ARM at 3.625% = $23,611 + $73,669 = $97,280

Thus the total interest paid for the (3.625%-8.625%) 7/1 ARM will be much higher ($97,280) compared to $80,983 paid on a fixed rate of 4.125%.

Exercise: Try the above calculations if the 7/1 ARM is kept for a longer duration (than 1 year) before a refinance to fixed rate. I believe the savings will be more as you are paying down more at lower rate of the 7/1 ARM, but then you are assuming the risk of interest rates as you delay further. 

So there are both behavioral as well as mathematical consideration behind such a refinance decision.

The most obvious behavioral factor is that ARM is riskier than fixed rate. This is the general notion and with good reasons. With an ARM, the interest rate risk is passed on to you by the lender and with the US economy seen an almost zero interest regime for a long time now, the long term outlook could very well be higher interest rates.

The fixed one comes with the peace of mind, and leaves you with easier refinance decisions in future if the interest rates go down further.  

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Posted in Liabilities and Debt

The Paid Piper of Hamelin

The title is from the childhood story where the Pied Piper helped a town get rid of the rats and drowned them in the river by playing his melodious music. The second part of the story is that after the rats were got rid of, the town did not pay him. So a very sad thing happened as he came back revengeful and wooed the children away.

I wish to relate this to the largest debt we take on in our lives, Home Mortgage.

One’s own home is a dream which everyone loves to live, but the mortgage is like the rat which becomes ubiquitous in our entire life (for 30 years and everyone holds one in his/her financial life).

The mortgage is usually a large amount (2-3x of annual salary) and the long period makes us imitate the Pied Piper with our finances.

The big question is should you pay up the mortgage, never have one at all, or let it continue while you build wealth by investing?

Mortgage has a number of factors – the monthly payment, interest rates, tax benefits, prepayment charges, points, refinance, fixed and adjustable, ARM and LEG and what not.

There are entire books on mortgage terms, strategies and nuances. Also there are countless arguments on which is better – paying off mortgage or investing the same money at higher risk/return.

The question is how do we become a Paid Piper from a Pied Piper? How do we get that relief when the rats are drowned? Or is life worth it when the rats are gone and the music has to stop? Will you feel betrayed like the Pied Piper once all your savings (hard work) are trapped between the walls?

This is a question I searched extensively for a solution but could not find any conclusive resources or guidelines.

Very recently as I bought a house in Texas, I have considered a number of strategies based on my prevailing financial situation.

I have no finance degree nor do I work in a bank or financial institution. But over the years I faced this question multiple times as I owned 3 houses (India and US), all bought with a mortgage and then paid up fully or partially.

This post is just to systematize this complex decision by taking into account a few personal finance factors. I hope this will help you make a better decision if you are grappling with the same question.

You can be in 3 situations that I have gone through and used all 3 strategies in the 3 real estate possessions.

  1. Lets call it A – The Paid Piper solution. You throw all your extra money towards the mortgage and pay it up as soon as possible. This is also the Dave Ramsey way, where Baby Step 6 says after you are consistently investing 15% of your salary and saving for kids education, you should throw all your extra money towards mortgage and become completely debt-free.
  2. Lets call it B – The Pied Piper solution. Here you keep paying the mortgage payment every month but also pay a little fixed extra, to keep chipping away at the principal. Although you can throw even more money, but you prefer to invest the extra money into stocks and REITs. Keep the music on and lead the rats slowly towards the river. Hopefully you earn from the residents of the town as they enjoy the music but gets rat-free as well. 🙂
  3. Lets call it C – The Rat Lover solution. Here the rat is kept controlled (by making regular payments only) and the music plays on for a long time and creates enough entertainment that the rat problem diminishes from the people’s mind. In other words, the mortgage is kept alive by making the payments while the investment portfolio (real estate or otherwise) keeps growing by acquiring more assets.

Now let us see what factors in your financial situation will or should make you follow either A, B or C strategies. These factors will never be exhaustive but the ones I am going to discuss are faced by me and used in my decision in all the 3 cases. You can apply them to your situation and according to your long term goals.

A – The Paid Piper of Hamlin 

  • The mortgage interest rate is very high compared to investment returns. An interest rate above 8% is almost always expensive as you will struggle to earn 8% on your money consistently from regular investments like stocks, ETF or mutual funds. It is a no-brainer that you should pay off as soon as possible, or refinance to a lower interest rate. If you manage to refinance, congratulations. You can follow B or C below.
    • This was my situation in the first house I bought in India where the interest rates were > 10%. I paid off the mortgage in little over 3 years as I absolutely hated the monthly payments and the stress on my budget. 10 years later, I still own the house which is now giving me a nice rental income with zero loan costs.
  • You have a decent rate 5-6% but not very low. You are not comfortable with debt and you really want to stay in the house for long term (10-15 years). This is your dream house and owning it free and clear will give you a peace of mind and pride too. By all means strive to pay it off.
    • This is Dave Ramsey way where he says wealth starts building up and you become generous when you have no more monthly payments.
  • But most important is to also look at your overall asset allocation if you have an affordable mortgage. How much do you have in Stocks and Bonds? A simple allocation is 33% Stocks, 33% Bonds and 33% real estate. You can modify the percentages according to your risk profile and age, but you get the idea.
    • Decide on an asset allocation and calculate where do your investments stand. Take into account the Equity you already have in this home as Real Estate. If putting more money into the Home is not going to disrupt your asset allocation and actually help build up the Real Estate Equity, go for paying up on the mortgage.
    • Be careful on this as you don’t want to be House Poor, where Real Estate allocation is like 80-90% and you are left with very little liquid investments. This can be really stressful when the economy is down and chances of emergency situations and job loss increase. Also not having cash means you will miss on the great investment opportunities that comes up during recession times.
  • All the above factors were justified in my case of my first house mortgage.
    • I had a high interest rate loan then and I did not see any way of refinancing. It was not so common those days or I did not bother.
    • I wanted to sleep better and own my first house. I happily stayed in the house for more than 10 years, paid it up and rented out when I moved to my second abode.
    • I was building my portfolio and paying it off just made the Real Estate part done. There was no REIT in India (they are coming now), and so the only real estate exposure was to buy a physical asset.

B – The Pied Piper of Hamlin

Here you play along but also have the task of paying off your mortgage in your plans.

This can be the real balanced approach and most financial advisers recommend this. You will read over the Internet about the biweekly plan, HELOC strategy, monthly extra payment etc. All these are good but lets see when you should employ this strategy.

  • You have a decent mortgage rate of 5-6% and you are a disciplined investor.
  • You budget every month and have the discipline not to blow up the extra money.
  • You are inspired by Dave Ramsey and you know after investing 15% of your salary into retirement accounts and investing for kid’s education, you have surplus that you can throw at the mortgage.
    • However this requires a lot of discipline and so Dave recommends a 15 year mortgage so that you are forced to increase your monthly payments.
  • I am a big fan of asset allocation. The beauty of this approach is that you can tweak the extra payments to balance your assets between Stocks, Bonds and Real Estate. If your real estate allocation is low, increase your extra payments and as the allocation comes closer to your desired one, reduce your payments and so on.
  • When I purchased my second house in India, I paid majority by cash (as interest rates are still high in the range of 8-9%) and took out a loan for the rest.
    • This let me continue investing in mutual funds and fixed deposits, while the mortgage payment earned me equity and further added to the Real Estate allocation.
    • I also paid extra every month due to following factors.
      • The house was brand new construction and my wife and daughter designed the interior beautifully. So we did not plan to sell it soon, but instead, planned to stay in it for the long haul like our first house. I eventually wanted to own it free and clear again.
      • The interest was high (typical in India) although the payment fit into my budget. The extra payment I could customize month to month and throw into the principal.
      • I could keep investing in mutual funds according to my worked out allocation, and at the same time apply for tax deductions on the mortgage interest.
    • However situations changed in about 3 years. We could not stay in this house for long, as my job required me to relocate to US.
      • Paying off suddenly became a priority if I had to keep the house.
      • Well I could have sent money from US every month, but that would have disrupted my other plans. More on that in later posts.
      • Due to complex international tax laws, I had to liquidate some of the mutual fund investments. It made sense to pay off the house than letting the money idle in savings accounts.
  • So if you have the discipline of working on a budget, you can chip away extra on your mortgage principal with two goals in mind.
    • Increase your Stocks and Bonds portfolio as you invest majority of your savings, thus keeping your asset allocation sane. The real estate down payment (typically 20%) itself creates a big skew in asset allocation. So you want to tune the extra monthly payments according to the asset allocation.
    • Eventually you want to pay off as you want to keep the house for long term.

C- The Rat Lover

Yikes!! Who loves a Rat? The investors of course… They love leverage and want their tenants to handle the rat, while they enjoy the music in terms of cash flow and asset appreciation. If you are really interested in this mode, I suggest read a lot of Real Estate Investment material to learn how to do it properly.

I have not done it intentionally but I have read a lot (I still scourge for such books and BiggerPockets.com).

In the USA, the real estate investing is popular due to the rent/value ratio being investor friendly in some regions and the overall mortgage rates are quite low.

So even if you maintain a mortgage, either the rent or your monthly budget can cover it. Of course, you should plan and budget well, and buy the house you can afford.

Now when should you play the Rat Lover? Dave Ramsey will not advocate this at any cost unless you are working on other high interest debt or you have no financial slack in your budget to pay off. The simple reason is this is risky and if you run into financial trouble, your beloved home can go into foreclosure.

But there is a deliberate situation of not paying off. I am not talking about real estate investing but as a homeowner like me. I bought my property in Texas in December 2017.

Here are the considerations and why I decided to adopt this 3rd strategy.

  • Since I did not have a credit score (no history in US), I could get a 7/1 ARM with a 3.625% interest rate. This was good as it perfectly fit into my budget owing to the low rate.
  • I did not then plan to keep the house for long term. It was a starting house in the US and everyone told me we will upgrade in a few years time (less than 7 years and hence the 7/1 ARM). So there is no point in driving down the mortgage with extra payments (except to save some interest).
  • Instead I should invest the surplus out of my budget in low cost index funds and increase my asset allocation. Note in my second house, as I liquidated some investments and paid off mortgage, my asset allocation is really screwed up hugely in favor of Real Estate.
  • Me and my wife renovated this house in Texas and brought the value up. I have not done an appraisal yet but I am sure it improved value by 10-15%. So now we want to keep this house for the long term. Even if we move out or move to another place, we can convert it to a rental as the mortgage interest rate is low.
  • Now there are two ways to hold this house long term.
    • I can focus on paying down the 7/1 ARM before it becomes adjustable and hits me with the interest rate risk (it will start floating in the 8th year). But this would have skewed my asset allocation further towards Real Estate.
    • I can refinance it to a fixed rate (now that I have a credit score and a decent one). I did exactly this and refinanced this month (the rates took quite a dip). Of course I could not get as low as the 7/1 ARM but very close to not affect the monthly payment too much.
  • Now I can invest entire savings every month and build up a portfolio of index funds. Once my asset allocation comes back in shape I will go back to strategy B and start paying off the mortgage.

Conclusion

Lets consolidate the factors and see if we can come up with a situational formula to decide what kind of Piper you will be.

Type A: The Paid Piper

  • You have a high interest mortgage. Always try to refinance to lower rates though.
  • Your asset allocation dictates you to increase the Real Estate portion. The principal payments towards your mortgage goes towards building the Equity.
  • You either have substantial liquid assets or are investing regularly to increase stocks and bonds allocation.
  • You want to stay in the house for long term and owning it free and clear will give you the peace of mind.

Type B: The Pied Piper

  • You have a decent mortgage interest rate (5-6 %) and can comfortably handle the monthly payments.
  • Your asset allocation is already balanced and real estate equity build-up is a part of your regular investment plan.
  • You plan to stay in the house for a longer duration, if not forever.

Type C: The Rat Lover

  • You have a good mortgage interest rate (< 5%). You obviously can comfortably handle the monthly payments.
  • Your asset allocation is already skewed towards Real Estate and adding more home equity will make your portfolio ill-liquid.
  • You have alternative plans of either converting this to a rental or you bought this property as an investment. Of course you should know how to manage rentals to generate positive cash flow.
  • You may move out of town or country in few years (the time is not fixed). You will have a choice then to sell it off or convert it to a rental. The fixed rate will not cause a change in your asset allocation or worry about interest rate movements.

Here are my 3 units portfolio.

 

So what do you think of the strategies mentioned? Let me know in the comments below!

Stay tuned for the next post on my blog about budgeting and executing these strategies.