30 year I/O question -Dave?

stinkboneMay 11, 2008

OK, I am refinancing a 1st and 2nd into a single 30 year fixed rate. I am debating between the 30 year fixed, and the 30 year fixed interest only. I like the flexibility of paying either just interest, or interest plus principle that the I/O gives you. The reset payment of the I/O @ the 10 year mark (where the loan becomes a conventional 20 year @ the same fixed rate) is the same as what we are paying now, which we can afford. My question is this: will that reset payment be lower if I make additional priciple payments, or will it be the amount calculated when the note begins with fewer payments?

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I think I know now. Looks like it resets to a 20year at whatever balance is left. Duh.

    Bookmark   May 11, 2008 at 3:50PM
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Hi stinkbone,

When I first read your message, I thought, "Oh, no ... running a mortgage for 10 years without agreeing formally to pay off a penny of the principal?"!

Dave doesn't mind people running a fairly substantial mortgage without their getting their shirt-tails tied into knots to pay them off ... if one uses the freed-up money to invest into worth-while assets.

But ... when one considers that a mortgage is an agreement to pay off a (usually large) loan making level rates of payment from the first month to the last, one knows that in the early years, when the loan is large, the amount of interest payable annually is large ... meaning that one pays peanuts on the basic principal during the whole of that first year.

In the later years, a very large component of the regular payment goes to pay off principal, as the amount of interest payable on that residual amount owing is quite small - but the borrower has been paying the same amount each time.

We've often been told that if one can make one extra payment annually (specifying that it's to be used totally to pay down principal) it'll probably make a larger payment of the principal that the total amount paid off on principal through all the rest of the year (or close to it). That will result in the loan being paid off much earlier than according to the original plan.

If you make that official plan, I hope that you'll make a deal with yourself to make that extra payment annually, or more if possible, even if it's not required. If you get someone to run down the effect that'll make in the date that your mortgage'll be paid off, you'll be surprised, I'm sure ... and substantially motivated to carry it out, if at all possible.

The people who pay bi-weekly are actually making that 13th month payment in each year, contractually.

What plans do you have in place to deal with an emergency? Unexpected illness, if not covered by medical insurance (and few offer coverage of the entire amount, and certainly not up-front ... but medical people like to get paid now, not in half a year ... with you recovering the amount from your insurance company, later). Blowing the engine or tranny of your car? Replacing a furnace ... it may make you sweat (sorry ... "perspire") to do without an air conditioner for a while until you can afford a repair or a replacement ... but you'd get more uncomfortable than that, doing without a furnace (without regard to tearing holes in walls to replace split parts of water pipes after freezing).

Will you be able to get a HELOC from your financial institution? For sure? I'll bet not ... if you've been put on lay-off (especially if permanent). And at what rate?

I suggest that, even if it means cutting expenses to just the bare essentials for a couple of years (or more), that you make a strong effort to set aside the value of a fourteenth month of mortgage payment each year, to invest as a safety net for use in emergency.

I've recommended to many that they try to have 3 - 6 mos. worth of income in case theirs stops, for whatever reason, so that they'd still be able to manage financially.

I've told a number of people, as they became more familiar with the ins and outs of capable financial management, that often I don't have such myself.

But I have a fairly guaranteed income, being as I'm on three pensions plus required annual withdrawal from a tax-deferred retirement plan, and live on less than that income ... automatic, until I depart this earth.

Even if I didn't, I have some equity and mutual fund assets and have had certificates issued ($35 - 50. per asset in stocks, usually fee-free for mutual funds) that I have lodged as collateral backing a Letter of Credit at my bank (which sits unused, most of the time, with no inactivity fee levied) which I can draw on in case of an emergency.

So I use credit card to pay for the emergency needs, then draw on the LOC in time to pay off the total owing on the credit card ... as I dislike paying their high interest rates ... I'd rather pay at a lower rate on the amount borrowed on the Line of Credit. Then, as I have surplus income (and I cut expenses to the bone, in such cases) to pay that loan off in full, as quickly as possible, partly due to interest not being deductible. After that, to put the amount that I was paying interest into my pocket. Where I'd keep it for a short while, then use it to buy more assets.

I agree with Dave somewhat, however ... in that I will, however use a different Letter of Credit (due to the interest being deductible) to use to buy assets, sometimes agreeing to pay interest only, and some principal if and when it suits me.

As I believed, back when I would have to pay 6.25% interest, that I could borrow to invest at nearly nil net cost ...

... so it should be true in spades, now that I can borrow for 4.75%.

What's better than putting your money into the bank?

Long term ... it's buying a piece of the bank!

For reasons that I've outlined elsewhere in these fora.

Good wishes for making a deal that you'll be happy with in 10 and 20 years.

Learn how money works ... an interesting hobby ... **that pays well**!!

ole joyful

    Bookmark   May 11, 2008 at 4:15PM
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I didnt know there were 30 year fixed I/O loans available. however i would discourage against this. by only paying interest for 10 years you are banking on the house value increasing to offset the lack of principal payments. This is a risk that is unecessary. the differences is probably no more than $300-500 (depending on the mortgage amount).

what is your plan for that difference?? do you plan on saving or investing it religiously? do you have a 3-6 month emergency fund??

take the 30 year fixed and put the risk on the bank with payback using cheaper and cheaper dollars.

if you dont have any savings i would still recommend use the traditional 30 year fixed and build up your savings.

    Bookmark   May 11, 2008 at 4:50PM
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Hi Stinkbone,

My question is this: will that reset payment be lower if I make additional priciple payments, or will it be the amount calculated when the note begins with fewer payments?

As you realized, at the 10 year mark (if you are one of the less than 1 in 20 remaining in that loan,) your new payment will be determined by the then-remaining balance of the loan.

Further, you literally have full control over what that payment's affordability will be if you aggressively fund your safe growth accounts (instead of sending additional principal to the mortgage bankers) as you can literally withdraw your growth funds the week prior to your reset and make a lump-sum principal paydown to whatever balance makes sense for you at that time... which you can determine by the calculations of what your ultimate payments will be.

It is, however, extremely unlikely that you would choose to do so... and here is why;

A) Less than 1 in 20 mortgage loans (30 year term) survive to see their 10th consecutive year without refi or sale payoff,
B) The AVERAGE North American ownership residency is 3-5 years, and employment mobility is a trend on the rise, to boot,
C) Inflation is at the foot of a hockeystick-chart explosion, and "inflation rolls down hill" which means that inflation ALWAYS trickles down to the ground (literally... the real estate of the country.) Housing turnover sales have slowed primarily due to a temporary credit collapse, but the "Lion over the hill" of impending inflation will have all real estate owners increasing their leases and rents (as is already observable in many markets.) This, in turn, will spur another extension of the real estate appreciation wave.

As your real estate appreciates (at roughly the rate of longterm inflation, plus the rate of national population increase,) your personal mortgage debt will remain unchanged, but the amount of your net worth entrapped in your real estate will grow significantly.

While the increase of net worth is a good thing (and you'll be able to thank yourself that you held real estate during inflationary times, for that,) the fact that you'll then be likely singificantly overbalanced in real estate as a PORTION of your net worth will become a dangerous thing... for risk reasons I have detailed here previously.

When you observe your "pie slice" of net worth tied in real estate equity growing beyond safe and preferable measures, you would be wisely advised to re-balance your equity among other asset classes more appropriate to your at-that-time personal financial profile and family goals.

As a real estate owner, this will not be an "if" but rather a "when." You can fairly simply and accurately forecast this on a spreadsheet by taking your current conservatively estimated home value, and compound it by a CONSERVATIVE estimate of future inflation plus national population growth. Forget the speculation cycles... regardless of temporary ups & downs, the real estate markets will (as they always always have) conform to inflation+population growth.

Take a look... it won't take longer than 4-7 years, very realistically, before you will be in a position where your personal portfolio balance sheet is overweighted in unleveraged, market-risk vulnerable real estate equity... and prudence at that time will be to rebalance for both protection, and to regain safe growth (unleveraged real estate gives you zero growth.)

Hope that all makes sense!

LASTLY... just to add a critical concept;
"Rates Are Relative."

That is to say; when interest rates are low for borrowing, the credited rates in growth accounts are in the same vicinity.
When interest rates are higher for borrowing, the credited rates in growth accounts are ALSO higher, in the same vicinity.

The KEY to longterm safe success is the careful BALANCING of your leverage with your growth strategies.
If you keep your eye on balancing, annually (at minimum,) you will have the greatest, safest, earliest results of financial independence.

All the best!
Dave Donhoff
Leverage Planner

    Bookmark   May 11, 2008 at 5:44PM
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Thanks for the advice all. We're covering the other stuff (retirement, college, emergency, term life), and the house is at 80 loan to value.

Dave, am I reading you right by saying one should "cash out" equity occasionally, or move, to redistribute net worth, and an I/O would be your choice since my $350 savings monthly could go to other investment options?

    Bookmark   May 14, 2008 at 4:19PM
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Hi Stinkbone,

Dave, am I reading you right by saying one should "cash out" equity occasionally, or move, to redistribute net worth, and an I/O would be your choice since my $350 savings monthly could go to other investment options?

Yes... assuming that your equity has become imbalanced to the point where you are losing protection and growth to a degree that the costs of the rebalancing are justified.

Dave Donhoff
Leverage Planner

    Bookmark   May 14, 2008 at 6:32PM
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You are RENTING the money from the bank and paying a lot more then a landlord would charge you....and now you get to mow the lawn, pay for all the repairs, taxes, insurance,and even paint it your own colors....great idea huh?

and the 30 year fixed interest only

    Bookmark   May 15, 2008 at 4:53PM
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