“Option adjustable-rate mortgages,” or option ARMs, became all the rage back in 2004. On the surface, they sure can look like a good deal: we get a nice, low introductory interest rate on the loan for the first few years or so, and not only that, we have a bunch of options for how we want to pay our mortgage every month. Low rates and flexible payment options? Sounds like a dream, right? After all, if our interest rates are low and we have the option of not making a full payment every month, then we can afford to get a nicer house in a better neighborhood.
But let’s back up to that part about not making a full payment for a sec. One of the most enticing things about option ARMs is also one of its most dangerous. When we have an option ARM, we can typically choose to make one of three types of payments every month. First, we can pay the principal and interest that are due for the month in full. This is ideal, and is how most traditional mortgages work. If we can’t quite swing that this month, we also have the option of just paying the interest. This is less ideal, because we’re not paying down the principal of the loan, and as a result, it’s just going to incur more interest that we’re eventually going to have to pay off as well. But if we’re in a real financial jam one month, we might decide it’s worth it to do it anyway. The third option is the minimum payment option, which allows us to make an itty bitty monthly payment that doesn’t quite cover the interest due and certainly doesn’t pay down the loan’s balance. This is pretty much the worst thing we can do, other than paying nothing at all. We’re not paying down the loan, we’re not paying down the interest, and now we’re going to end up paying interest on interest. The overall amount we owe is increasing, not decreasing, and if the value of our new home isn’t also increasing, we’re going to find ourselves upside-down on our mortgage and potentially in danger of losing the house. This is bad, bad, bad.
It’s so bad, in fact, that economic analysts tend to give option ARMs a big ol’ frowny face accompanied by two thumbs down. In fact, many of them say option ARMs are partially responsible for the subprime mortgage crisis of 2007-08: as housing values fell and the job market deteriorated, people who probably shouldn’t have gotten approved for big mortgages anyway found themselves unable to make loan payments and unable to sell their home for anything near what they’d paid for it. Not only that, but remember that nice, low introductory interest rate we mentioned? Yeah, that’s only in effect for the first few years of our mortgage. Once that rate expires, the mortgage adjusts to the current market interest rate, which is, of course, much, much higher than the intro rate. This means the mortgage payments themselves are much higher, and if we’re consistently making minimum or interest-only payments on the loan, those higher rates can mean we’ve signed up for a mortgage we’ll never be able to pay off.
But look, it’s not all doom and gloom in the option ARM world. There are homeowners out there who can really benefit from this type of mortgage. Like...let’s say we make a quite decent amount of money and are certain we can pay off the mortgage in its entirety before the introductory interest rate expires, or soon thereafter. Or let’s say the payment options appeal to us because, even though we make enough annually to comfortably make our mortgage payments, our income isn’t the same from month to month. An option ARM gives us the choice to make a full payment this month, an interest-only payment the month after, and then a double payment the month after that to make up for the second month. So that can be helpful. But by and large, if we’re considering buying a house or refinancing an existing home loan, we should definitely read all of the fine print—and make sure we can actually afford the loan—before we sign on any dotted lines.
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Finance: What are the components of a mo...1 Views
Finance Allah shmoop What are the components of a mortgage
payment All right so here's a weird thing about mortgages
When you borrow say four hundred grand buy a home
and say in a six percent fixed thirty year interest
you'll end up paying way more than the four hundred
grand just in interest Renting the money Think about it
Well you'll have a monthly pay payment of twenty four
hundred bucks and by the time you've made thirty times
twelve per year or three hundred sixty payments you'll have
paid some four hundred sixty three thousand dollars in interest
charges Seems like a lot of money to pay out
of your own pocket But since mortgage interest is usually
entirely tax deductible well the rial cost to most home
borrowers is actually meaningful E less than that six percent
interest maybe something closer to a three and a half
four percent something like that So while yes on a
total gross basis you will have paid out more than
the amount borrowed over the thirty year course in the
mortgage you'll also have been forgiven loads of taxes And
for what it's worth over most thirty year time periods
in history the market has gone up about eight to
ten percent a year on average Compound did something like
that So you feel the people mover floor moving fast
underfoot with inflation pushing things around as you go along
Well the money you borrow is the principal of the
loan and that number usually declines by a small amount
each month As you make a flat payment and it's
usually gradually paid off Check out what the principal of
four hundred grand looks like for the first twelve months
of payments right here Note that the flat monthly payment
is twenty four hundred dollars and see how the principal
payed as part of this payment loan thing there goes
from paydown of three hundred ninety eight dollars Teo Well
four hundred twenty a year later right Like you're paying
off principal little by little So you have less that's
attributed to interest And Mohr that's attributed to principal pay
down as you go along and note that this assumes
Ah flat monthly payment here Right You're paying the same
amount You're one you would You're thirty two thousand three
hundred ninety eight dollars and twenty cents on this particular
alone So after a year the amount owed an interest
is well just slightly last Here in this example it's
one thousand nine hundred seventy seven bucks down from in
a two grand and note what it looks like at
the end of each of the first five years That's
a big shift from almost entirely interest do now Principal
being ah meaningful part of it you got after ten
years right here and then at the halfway point in
fifteen years it's here So I noticed that the amount
owed at this point is roughly half the total Why
Because the lion share the pay down went to interest
in the first half of the life of the mortgage
AII those first fifteen years and well then in the
back half way more will be attributed to a principal
pay down than to interest Like check out what the
very last month's payment looks like It's just twelve dollars
of interest and two thousand three hundred eighty six dollars
of principle All of this is principal until well then
the balance is zero and we'll finally Then you will
have fully paid off your mortgage and own your home
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