When a mortgage rate adjusts, who gets what? (#2 in the Mortgage series)

Here's the second in a series of posts about mortgages.  The first, about fixed rate mortgages, is here.

I ran a spreadsheet that looks at the effect of a 2% increase in mortgage rates.  It assumes a 30 year term, principal of $100,000, and a range of mortgage starting rates from 3.5% to 6.5%, which adjust up by 2% at the end of the first year.  Here are a few factoids:

1. Monthly Principal and interest payment per $100,000 of principal:

• At 3.5%, $449
• At 5.0%, $537
• At 6.5%, $632

2. Allocation of First Payment:

• At 3.5%, 35% of one's first mortgage payment is principal; 65% is interest.  ($157 principal and $292 interest)
• At 5.0%, 22% is principal, 78% is interest.   ($120 and $416)
• At 6.5%, 14% is principal and 86% is interest.  ($90 and $541)

3. Allocation of Twelfth Payment:

• At 3.5%, 36% of one's 12th payment is principal
• At 5.0%, 24% of one's 12th payment is principal
• At 6.5%, 15% of one's 12th payment is principal

4. After one year, the balance on a $100,000 mortgage is

• At 3.5%, $98,081 (1.9% paid off)
• At 5.0%, $98,525 (1.5% paid off)
• At 6.5%, $98,882 (1.1% paid off)

5. After one year, the rate adjusts upward by 2%.  The new monthly payment, amortizing over 29 years, is

• At 5.5%, $565
• At 7.0%, $662
• At 8.5%, $776

6. The new monthly payment as a percent of the original payment is

• At 5.5%, 126%
• At 7.0%, 123%
• At 8.5%, 121%

7. Interest has risen, from the 12th payment to the 13th, by

• At 5.5%, 57%
• At 7.0%, 40%
• At 8.5%, 31%

8. The monthly principal payment has fallen, from the 12th payment to the 13th, by

• At 5.5%, 29%
• At 7.0%, 30%
• At 8.5%, 32%

9. Allocation of 13th payment:

• At 5.5%, 20% of the 13th payment is principal, 80% is interest ($115 principal and $450 interest)
• At 7.0%, 13% of the 13th payment is principal, 87% is interest ($  87 and $575)
• At 8.5%, 9% of the 13th payment is principal, 91% is interest   ($  66 and $700)

10.  Allocation of 24th payment:

• At 5.5%, 21% of the 24th payment is principal, 79% is interest ($121 principal and $444 interest)
• At 7.0%, 14% of the 24th payment is principal, 86% is interest ($  93 and $569)
• At 8.5%, 9% of the 24th payment is principal, 91% is interest   ($  71 and $695)

Some observations:

1. People who at 6% interest rates might be renters might rationally choose to become homeowners at 4%, particularly if told by a real estate agent they think is representing their interests, or a mortgage broker who wants to make a sale, that rates probably won't rise.  [And the Realtors' ads would certainly give the potential buyer the impression that "their" real estate agent is working for them.  A first-time homebuyer, particularly a first-generation homebuyer, wouldn't be able to parse the truth of the message of those ads.  Among other places, I've heard these ads on stations targeted to minorities, and aimed at first-time buyers.]

Note to first time buyers: 1. "Your broker" does not work for you.  S/he works for the seller, and is paid by the seller to make the deal close, not to represent you or protect your interests, or even to give you good advice.  2. "Your" broker is paid by the seller, and only gets paid when the deal closes.

2. A 2% increase in the mortgage interest rate (from 3.5% to 5.5%) increases the lender's take by 57% and reduces the monthly paydown of principal by 29%.  A 2% increase from 5.0% to 7.0% increases the lender's take by 40%, and reduces the monthly paydown by 30%; a 2% increase from 6.5% to 8.5% increases the lender's take by 31% and reduces the monthly paydown of principal by 32%.

3. Refinancing that mortgage into a fixed rate causes the borrower to repeat the first year of payments, when a large majority of the payment goes to paying interest.

4. Refinancing a mortgage moves one from being in, say, the 3rd year of a 30 year mortgage to being, effectively in the 3rd year of a 33 year mortgage.  That is, the payoff date has been pushed out.

5. Purchasing a move-up home has many of the qualities of refinancing the mortgage on the first home.  

Comments

[JMK]

ARMs (adjustable rate mortgages) are ONLY viable when interest rates are high (certainly above 6 or 7 percent).

In that environment, you're betting (wisely, I might add) that interest rates, long term, will probably decline, so you pay a very low rate up front and can often refinance a few years down the line at a lower fixed rate.

People who take on ARMs when interest rates are low, as they were between 2002 and 2006 are taking an incredible risk, as there's little question their rates (tied as they are to the Prime rate) WILL rise and it's NOT a wise bet to think that fixed rate mortgage rates will come down BELOW their historic lows any time soon.

AGAIN, there's no reason for a person to be "snookered." The research is OUR RESPONSIBILITY and EVERY bank and EVERY lender (mortgage broker) will give you the payback rates, etc.

I've bought three houses (and sold two) over the course of my life to date) and EVERY TIME, I did the research on what the costs would be (the repayment rates, the property taxes factored in monthly, average utility costs on that house, our living expenses, ETC.

EVERYONE involved in ANY process is there to MAKE MONEY. It's YOUR job and MINE to protect our own interests by doing "due dilligence" - the required research involved.

[LVTfan]

I can't disagree with anything you've said here.

But the time and ability to do the due diligence does not fit with everyone's aptitudes or ability to hire the sort of help it takes to do that DD.

The whole subprime experience leads me to wonder how soon it will be that someone proposes, again, that we should privatize Social Security and permit people who didn't have the time or skills or resources to research a mortgage fully to take full responsibility for investing their retirement funds themselves.

IBM's employees, for many decades, had specialists doing that. They didn't expect even their brightest computer scientists to also be experts in investments. (Now new employees are on their own, with 401(k)s. Likely theirs are better chosen than in many corporations, but I'm willing to bet that the aggregate results on those 401(k)s are far below what IBM's pension fund achieves year in and year out.)

Then, of course, one could hire someone for a mere 1.5% of assets each year. And probably not do too much better.

That will be another post.

[JMK]

Here's the thing, we ALL do that same "due dilligence" and research when we buy a car, or make any number of purchases...at least MOST people do.

It really doesn't take all that much aptitude to figure out how much one takes home in total income and then begin deducting one's expenses new/upcoming or old/current ones and deciding if we can take on a certain mortgage or not.

You don't even need the banks to give you that payout sheet, as a rule of thumb 6% over thirty years is roughly $600/mth, take a percentage as "roughly" $100/mth gives you a rough and if anything, a slight OVER-estimation of your mortgage costs, then just add your new property taxes, utilities, etc.

The primary problem with the sub-prime mess was actually the REVERSE of what most Liberals are claiming it is - it's due to OVER-regulation, not any lack of regulation.

The push by the likes of Frank and Dodd to force banks to loan to "poorer Americans" by eviscerating traditional lending standards was the PRIMARY cause of the current crisis because it created an ethos of poor judgment and low standards.

The most recent collapse was brought on by Fannie Mae and Freddie Mac (two GSEs that SHOULDN'T even have existed) who bundled hundreds of BILLIONS of dollars in "BAD" or HIGH-RISK loans and sold them as "government-backed mortgage securities" to unsuspecting institutions on Wall Street.

When that "bad paper" began to have itstoxic effects, smart investors, like Hedge Funders took advantage of that situation by short-selling those financial stocks (Bear Stears, Merril, etc.) and as their stock prices went down, those companies couldn't get the loans THEY needed!

The result was the collapse of many major companies and the loss of tens of thousands of jobs.

Free Market supporters oppose the bailout on the grounds that "we should just let this Corporatist economy die its natural death" - ain't gonna happen, so the bailout will.