This ARM could cost you an arm and a leg

Whenever I meet with a homeowner to discuss the Home Ownership Accelerator,  I always look at different scenarios based on their actual cash flow.  The Home Ownership Accelerator is an adjustable rate loan that adjusts monthly based on the 1-month LIBOR index.  The loan allows you to take a higher margin and pay less up front or, you can buy the margin down.  You pay 2 points up front to buy the margin down 1%.  In general, your break-even point is two years because you prepaid 2% interest up front to pay 1% less per year thereafter.  However, your cash flow may be so strong that the higher margin makes sense.  I've seen this happen several times.  Here's an example.  I had a husband and wife come to see me and they have good but modest income and no outstanding debt other than their 15-year mortgage on which they had about 10 years left to pay.  I ran the simulator using a margin of 3.25% over the 1-month LIBOR which historically has averaged about 4.5%.  That makes for an average rate of about 7.75%.  Then I added 5 points to the starting balance to reduce the margin to .75% which would mean an average of about 5.25% over the life of the loan.  Here are the results:

• Using the high margin, their home would be paid off in 6 years and 9 months.
• Using the low margin, their home would be paid off in 7 years and 4 months.

This example shows that the actual rate you get is not as important as the actual dollar amount you pay in interest.  You can't take your family to Disneyland with an interest rate.  You can with the thousands you save in actual interest paid.

So the conclusion we can draw from this is that if your cash flow is strong enough, you may not want to buy down the margin.  On the other hand, if two years is the break-even point for buying down the margin, this loan could cost you an arm and a leg but you get your arm back the first year and your leg back the second year.

How powerful is your cash flow?