by Archie M. Richards, Jr., CFP^®
September 2, 2002

Eddie writes about the 1-year adjustable rate mortgage I referred to recently. The interest is 1.875 percent with 6½ points. (Having sold over 4,000 of this wonderful loan, silly usury laws are forcing Quicken Loans to discontinue it. I refer to it anyway to answer Eddie's question.

"Won't the interest rate you pay go up in the second year?" he writes.

Yes, Eddie, it would. The interest is adjusted every year, at the rate of the then-current 1-year Treasury Bills plus 2.75 points.

Assume you need to borrow $100,000, but you add the 6½ points to the balance, making $106,500. The loan lasts for 30 years.

In the first year, the monthly payments are $387.

We're going to compare this loan with a 30-year fixed-rate mortgage whose interest is 6 percent. Having no points, that loan starts at $100,000. The payments would be $600 a month.

In the first year, the 1.875-percent loan saves $213 a month ($600 less $387). Don't spend this money. Invest it every month in an asset allocation investment program, as suggested in the 5/27/02 and 7/8/02 columns you'll find in www.archierichards.com.

Assume the investments grow at 9 percent a year. (I expect better.) At the end of the 1st year, after 12 deposits of $213, the investments are worth $2,664.

I'm assuming the worst case for interest rates. For the 2nd year of the adjustable rate mortgage, higher interest rates cause the rate to rise the maximum 2 points. The second-year rate is 3.875 percent. The monthly payments are $497.

During the 2nd year, you can invest only $103 a month ($600 less $497). The investments grow from $2,664 to $4,190.

For the 3rd year, the rate on the loan goes up another 2 points, to 5.875 percent. The monthly payments rise to $619. This is $19 more than the $600 you would have paid each month for the 6-percent, fixed-rate mortgage.

You continue paying $600 a month yourself. The additional $19 is drawn each month from your investments. Still appreciating at 9 percent a year, the investments grow slightly during the 3rd year, from $4,190 to $4,351.

For the 4th year, assume that the rate on your mortgage hits the lifetime cap of 6.875 percent. The payments are $682 a month.

You continue paying $600 a month, but $682 is needed. The $82 monthly difference you remove from the investment program. In 5½ more years (a total of 8½ years), the investments are reduced to zero. If the rate stays at 6.875 percent, you're stuck with the $682 monthly payments for another 22 years.

As I say, all of this assumes the worst case on interest rates. Oh, the rate on this mortgage will rise in the second year and maybe the third. It could hit the lifetime cap, but I doubt it.

I think the ingredients are in place for lower interest rates in the economy. A bonanza of tremendous technological developments approaches. The productivity of American workers, already high, will rise to levels never before known.

Higher productivity means more goods and services. The growth of goods and services will outstrip the supply of money, causing inflation to diminish even more than it has. As inflation falls, so do interest rates.

Within 5 years or so, I expect the rate on 1-year Treasuries, now 1.75 percent, to drop to about 0.5 percent.

Assume the balance of the loan has been reduced to $100,000. The rate on the adjustable rate mortgage is 3.25 percent (0.5 percent plus the 2.75 point margin). The payments are $487.

Every month, you add $113 to the investment program ($600 less $487). Growing at 9 percent a year for 25 years, the ending balance is $126,328. This is money you wouldn't have at all if you chose the 6-percent fixed-rate loan, even though your expenditures are the same.

The adjustable-rate mortgage is riskier, of course. I might be wrong about interest rates, and the investments may not grow at 9 percent a year. Plus, investing excess funds into or out of the investments requires diligence.

But to me, low interest rates, high points, and investing are the right course.