Q: I just bought a home in San Diego, California, for $439,000 with a 5/1 adjustable rate mortgage (ARM). This is a no-money-down loan. This is the only way I could get into the house at this time.
Is it a good idea to pay an extra $100 per month towards the principal? Will this substantially reduce my payment once I start paying interest and principal?
A: Did you get an interest-only loan? From the sounds of it, you may have an interest-only, zero down payment loan that will allow you to pay only the interest for a period of years, before the loan converts and you must start paying principal and interest.
The answer to your question is, yes. It’s usually a good idea to pay something toward the principal each month. While it will decrease your payments somewhat once you start paying principal and interest, there is another, more important, reason to do it: If you don’t do that, you will not add to the equity in your home. Any equity will be built by price appreciation.
Right now, home prices are booming in San Diego, as they are in much of California. But fifteen years ago, when I first started writing about real estate, southern California and the Northeast experienced a housing bust, and home prices sank like stones.
If you had bought your home then, without a down payment, and with an interest-only loan, you would have soon been “upside down.” That means you would have owed more on your mortgage than the house was worth. That happened to thousands of homeowners, who found out they had lost everything because they had to sell for less than they owed.
Mortgage lenders also took a bath, recording thousands of “short sales,” in which they received a lot less than the mortgage amount that was owed.
Prepaying your loan even $100 per month will help you get ahead of the curve, and allow you to build in a little cushion, even if your home does not appreciate substantially in value over the next few years. That’s extremely important in your case, since you’re not putting down a dime on this house.
What you may want to do is try to prepay your loan as much as possible over the next couple of years while keeping an eye on where home prices are going in your neighborhood.
In two to three years, if interest rates are fairly stable or go down and the value of your home has risen, you may wish to refinance your mortgage to a more conventional loan where you pay principal and interest.
You may find that refinancing has the added benefit of getting rid of some of the private mortgage insurance you may be paying (which is a hefty monthly cost for a zero down loan). You may even find that without your PMI payment, and with the equity you’ve now got in the home, your payment might be nearly the same as what you were paying before.
As for a 5/1 adjustable rate mortgage, I’m a fan of them in generalÃƒÆ’Ã¢â‚¬Å¡Ãƒâ€šÃ‚Â for financing homes as the payment is fixed for the first five years and is significantly lower than a 30-year fixed rate mortgage. In fact, I’ve got one myself.