I just locked in a 7 year ARM the other day at 2.875%. No doubt that is one of the lowest mortgage rates in decades and it is one of the primary drivers of my buying a house at this time after renting for about 12 years. In the economic analysis the low interest rate environment allows the cost of buying to trump the cost of renting. Intuitively people know that when interest rates drop by 25% then the cost of owning (exclusive of property taxes and assessments) should drop by 25%. Housing affordability has never been better.

However, when people analyze the economics of a home purchase decision the vast majority often look at the cost of ownership in a much different way. Instead of focusing on the real economic cost they focus on their monthly payment, which they incorrectly compare to their monthly rent. But when you own a home your monthly payment consists of both principal repayment and interest. Sure…your monthly cash flow is impacted by your mortgage payment but in reality only the interest component is a real cost, while the principal component is a form of forced savings. Let’s look at the difference.

If we assume that you borrow $200,000 at 4% then your monthly payment on a 30 year mortgage would be $1990.82, 30% of which will be principal repayment in the first month. However, at 3% your monthly payment would be $1758.09, 41% of which would be principal repayment. Note that while your interest expense has in fact gone down by 25% your monthly payment has only gone down by 11.7%.

There are any number of mortgage calculators out on the Web that you can use to evaluate your own personal financial situation. While you may need one of these calculators to help you figure out your monthly payment it’s always easy to figure out your interest cost in the first few months. Basically you just take your mortgage balance, multiply it by your interest rate and then divide by 12.

Oh…and there is one other consideration that people usually forget about in performing this financial analysis: the cost of the down payment. Most people assume that their only cost is what they pay the bank each month but in reality there is a cost to having your cash tied up in a down payment on a house as well. That cost is a direct result of what else you could be doing with that cash – e.g. pay down a credit card balance, invest it, etc… So you can calculate the cost of having your money tied up by applying the alternative use rate to your down payment. Or you can do what I do to just simplify the whole process and apply the current mortgage rate to the entire purchase price of the home, which simultaneously estimates the cost of both the mortgage and the down payment. As we used to say when I worked on military reconnaissance devices: it’s close enough for government work.

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Gary, I’m curious about the decision to go with a 7-year ARM. Given what you know now what do you think you’ll do in 7 years?

And did you come close to choosing a 15-year mortgage since it’s not that much higher than the ARM you got?

Yeah, I don’t think I’ll stay in the place more than 7 years. If I was going to stay much longer than that timeframe I would have probably gone with a 30 year mortgage. The reality is that given my age, the fiscal condition of the city, and the weather I can’t see myself staying here that long.

As for a 15 year mortgage…my goal is to borrow as much as I can at these low rates and invest as much as possible. I can get a much better return than what this money will cost me. A 15 year mortgage has you paying back a much larger principal amount – you effectively borrow less.

Gary, I’m curious as well. Didn’t a lot of people get burned when the ARMS reset and they couldn’t refiance? Granted some got lucky when rates dipped again.

Are you sure you will be able to sell in 7 years?

You can always sell. You just might not like the price. I have to believe that prices will be higher in 7 years.

A lot of the ARM resets happening now are pretty good for people.