The truth about cheap Money/ ARM LOANS continued..

The 1.75% rate is the interest rate you pay during the "teaser" portion of the loan. It is the MINIMUM payment required . . . like a credit card.

It isn't the interest you are accruing - that's probably 4% or more . . . but to make it easy, lets say it is four.

Where does the other 2.25% go? Oh, well, since you still owe it, it goes on your loan balance . . . and at the end of a year (or the teaser period) you owe more money (maybe a lot more money) than you did when you started making your little bitty payments.

That's neg am. Negative amortization. It may be that the appreciation where ever you are is SO HIGH that negative amortization doesn't bother you . . . You may be getting out of that property so fast you want the absolute lowest payment possible. This is it, but at a price.

Do the math the most simple way . . . a $500K mortgage with payments at 1.75% i/o = $729.17

The same mortgage with 4% payments (the interest you actually owe) = $1667.00

So in 12 months, you'd have added $11,253.96 to your mortgage balance from unpaid interest. Sorta eats into your profit margin doesn't it? That's $973.83 a month that you aren't paying; and you owe it.

It means that the first 2.25% of appreciation is gone right there in unpaid interest. If housing values are skyrocketing in your neck of the woods - say 6% or more then maybe you've made some money; $30,000 less $11,253.96 is $18,746.04. But it cost you $8K in closing costs and prepaids to get in the house, and if you sell through a realtor and pay 6%, well you see where this is going . . .

Now an interest-only loan is not in and of itself a bad thing . . . there are three year i/o arms, five year i/o arms, seven year, ten year and now there is a 30 year fixed rate mortgage with a ten-year interest only period. You pay only interest for ten years. The rate never adjusts, and in the eleventh year, you pay principal and interest on a twenty year amortization. (That's a whopping adjustment to your payment, by the way . . . same house as above, $500K, 5.5% interest only for ten years - the interest only payment = $2291.67; after ten years the payment is $3439.77.)

We Americans change mortgages in five to seven years, so the life of this loan really isn't expected to go to the eleventh year, but if it does, you'll see a $1,148.10 increase in your payment.

Realistically, you are gonna sell or refinance before then.
But, it will adjust seven years later than the three year arm adjustment, and the rate NEVER changes. (I'm a Scorpio, I go for security in some things)

You can use the interest only products to do a multitude of things:

Buy time until the property appreciates - three to five years; (Do not use this time and the extra money to go to Las Vegas or the Caribbean)

Spend the difference in the payment investing in something that is going to pay a return so that your house is in effect working for you;

or my own personal (and more complicated plan) . . . I'm spending the difference on improvements to my house. I have a three year interest only arm, the payment is lower than that of the house I left and more expensive by $100K. The extra money is going into a new gourmet kitchen, redoing the front porch, tons of other smaller, more boring things that an old house needs. When I'm done, and my three years is up, my house will appraise for much more than it did when I bought it (appreciation + improvements) and with any luck, I'll get an 80% loan to pay off the 80/10 piggyback I have now, and in so doing will still avoid PMI.

Ironically, pricing on the arms at the date of this writing is a little skewed . . . the three year arms are a higher rate than the five year arms, and the seven year arms are so high, you'd be better off in the thirty year rate. (Even Greenspan hasn't figured this stuff out . . . see my notes on Washington is baffled)

I don't like the six month arms because they are only fixed for six months. My partner got a six month interest-only libor loan a year before I got my three-year arm. His rate is now higher than mine, and will keep adjusting for the next two years. Mine is fixed for two more years. He saved money the first year, but he may (who knows?) spend it on a higher interest rate for the next two years . . . Or he may buy another house and get a different loan.

We are, after all, a very mobile society . . . and the life of our loans is three to five years . .

I could not find the author's name on this info, but you can find him or her on bloglines under finance.