Thursday, January 3, 2008

ARM Loans

I started this post out talking about the holiday blues of credit card bills, so that topic serves as a preface to the subject actually listed here. My apologies for any confusion.

No, I'm not talking about the depression people feel after the holidays are over. I'm talking about the depression people feel when they open their credit card statements or bank statements and see what they owe or what they spent on Christmas. This year my family managed to spend a little less thanks to minimal travel, but we still had our fair share of bills to pay. That said, I think my wife and I will be in the best financial shape we've managed in years. We will only owe money on our house and current credit cards by the middle of next month according to my estimates. I won't pat myself on the back, though, since we haven't suffered what Dave Ramsey calls "rice and beans dieting" to manage our debt relief. We've just found a little hear and there to get ourselves in a good position to quit owing money. Once we've paid off our other short term debts, we plan to set aside the debt payments in an interest bearing account and pay down a large chunk of our home loan with it just before our Adjustable Rate kicks in next February.

When we bought our home, we got some good advice that made a lot of sense. We took an ARM loan instead of a fixed rate mortgage. By paying the same amount to the ARM that we would have paid to the fixed rate mortgage, we reduced our principal balance faster and then even a significantly higher interest rate would cost less overall thanks to the reduction in principal. The mechanics look something like this:

4.5% ARM rate versus 5.375% fixed

If our house payment would have been $1200 under the fixed 5.375% but are instead $1050 under the ARM, we get to put an extra $150 a month onto principal for the first six years, or in total dollars that is $10,800 more we have paid against our loan. Even if the rate goes up 2% each year (the maximum allowed, up to 6% more overall), that 6.5% (and later 8.5% and 10.5%) is on $10,800 less money. In the end, the loan can be paid off faster, or at least with lower total interest.

Any time more money can go to principal faster, a loan will get paid off faster. That sounds redundant, but it escapes many people. Where a lot of people have been hurt in the past with ARM loans (and interest only loans) is they do not overpay the required payment, and then the adjustment really hurts them. It makes sense for us to stick with this loan until just before the ARM rate adjustment, and then to refinance the lesser amount on a fixed rate, or possibly get another ARM loan for six more years of slightly lower interest.

This post has been poorly put together, but I'm posting it now just because I know it's been a while since I've posted.

-- Robert

1 comment:

le35 said...

First of all, most arms are either 3 or 5 years (Ours is a 5 year instead of a six.) Second of all, I really like having an arm for just the reasons you stated. The post did seem to make sense