Repayment Planning With Two Mortgages: Which Do You Pay First?

April 17, 2006

"My wife and I recently purchased a new home and avoided mortgage insurance by taking a piggyback: Our first mortgage is a 5 year interest-only ARM for $296k @ 5.375% for 30 years. Our second mortgage is a 15 year FRM for $55k @ 7.01%. Our cash flow allows us to pay more than the interest on the ARM and the full payment on the FRM. Should we apply the excess to the ARM or to the FRM?"

The general rule is to pay down the higher-rate debt first, which is the second mortgage. If both mortgages were fixed-rate (FRMs), this would be a no-brainer, you would allocate all surplus cash to the second until it was paid off. The same is true when the first mortgage is a 5-year ARM and you confidently expect to be out of the house within 5 years.

On many piggybacks, the first mortgage is fixed and the second adjustable with a higher rate. In this case also you would channel excess cash flows toward the second.

But if the first mortgage with the lower rate is adjustable and your time horizon extends beyond the first rate adjustment, or if you are uncertain about it, the decision is trickier. While you should start by paying down the higher rate second, if market rates spike during the first 5 years, the rate on the ARM could jump by as much as 5% at the first rate adjustment, which would bring it to 10.375%. In that case, at some point before the rate adjustment, you should start paying down the ARM.

I can’t tell you exactly when to do this, you will have to rely on your gut.

But your gut needs to be kept informed regarding the ARM rate expected at the first rate adjustment. This is easy to do but you must know the index used by your ARM, the margin, and the caps, all of which are shown in your note.

The expected rate at the first rate adjustment is the most recent value of the index, plus the margin (which doesn’t change), subject to caps. Usually the rate on a 5-year ARM cannot increase by more than 5% at the first adjustment. As the index changes over time, the expected rate changes correspondingly.

If the expected rate climbs above the rate on the second mortgage, you have to think about whether and when to switch gears. The case for the switch gets stronger the higher the expected rate and the closer you get to the ARM rate adjustment.

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