I use an adjustable rate mortgage (ARM) for a number of reasons on my rental properties and my personal property. I can get more than four loans on a property with ARMs, the rates are lower and at one point I used to pay off my mortgages quickly. Many people feel that an ARM is very risky because the rate can increase over time. It is true that many ARMs are risky and they are not the best option for many buyers. For some home owners an ARM can be a very good loan that saves money, lets you buy more properties, and is not very risky.
What is an Adjustable Rate Mortgage (ARM)?
Adjustable rate mortgages or ARMs have gotten a bad name the last few years, because many people used them to buy houses they could not afford before the housing crisis. An ARM is a loan that starts with a low interest rate, but the interest rate can increase after a set period of time. A 5/30 year ARM is a 30 year loan with an initial rate that is fixed for the first five years, but can increase on the sixth year. There is a cap for how much the interest rate can increase after the adjustment period, and a minimum it can decrease. An ARM can adjust up or down depending on what interest rates do. On my loans the rate might start at 4.5 percent, but could raise up to 8 percent. The rate cannot increase more than 1 percent in any given year.
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Adjustable rate mortgages have lower interest rates than fixed mortgages
I like 5 year ARMs because they have a low interest rate guaranteed for 5 years. ARMs can have rates that are 1 percent less than a 30 year fixed rate loan. That 1 percent difference in interest rate can save hundreds of dollars a month. If you heard horror stories about ARMs in the past, there were some people who used them carelessly. You used to be able to get ARMs with very low rates that would jump to very high rates after only one year or 6 months. Many times buyers could not qualify for a home with the normal 30 year fixed rate loan, but they could qualify for the lower payment the ARM offered. I would not suggest using an ARM because you cannot qualify for a 30 year fixed rate mortgage.
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What are the basics of buying a house?
An adjustable rate mortgage may be your only choice to finance multiple properties
Another reason I use an adjustable rate mortgage is they are one of the few options available from my local lender. I use a portfolio lender who lends their own money on loans; they do not sell their loans to other companies or investors like most banks do. My portfolio lender offers a 5 year and 7 year ARM as well as a 15 year fixed loan. The 5/30 year ARM has the lowest payment, lowest interest rate and works perfect for my cash flow strategy. The reason I use a portfolio lender is many lenders will not loan to investors when they have more than four mortgages. My portfolio lender will lend on as many loans as I can qualify for, but I must use their limited loan options. Portfolio lenders can also be a great option for getting a loan on a home that needs repairs. Here is a great article on other ways to get financing when you have more than four mortgages in your name.
Are ARMs riskier than a fixed rate loan?
ARMs have gotten a bad name the last decade due to the high number of loans that were foreclosed on during the housing crisis. The reason so many people lost their homes with an ARM was they qualified on the low initial interest rate. When the rate on the adjustable rate mortgage went up after five, three or even one year, the home owner could no longer afford the payment. If you are thinking of getting an adjustable rate mortgage, make sure you can afford the payment increases even if you think you will have the loan paid off by then. Do not depend on being able to refinance to get yourself out of the loan. Buy properties below market value, and this will allow you to sell the home as well.
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An adjustable rate mortgage may be cheaper than a fixed rate loan
The interest rate on an ARM is lower in the beginning of the loan than a fixed rate loan. The ARM may be cheaper than a fixed rate loan even if you do not pay off the ARM right away and the rate increases. During the five years that the ARM is at its low rate, you are saving money every month over the fixed rate loan. Even if you don’t pay off that ARM and the rate adjusts, it would still take years for the total cost of the ARM to catch up to the fixed rate loan. If you reinvest the money you are saving from the ARM and make a higher return on that investment than the interest rate on the loans that will make you even more money. It usually takes 8 years and an ARM adjusting to its maximum amount, before the fixed rate loan saves you money.
Conclusion
An Adjustable rate mortgage is a great loan, especially when you have few other options. Be smart when deciding to use an ARM and it can be a great tool for any investor. The biggest mistake you can make is not being prepared for a payment increase if you are not able to pay off the loan or refinance. If you are prepared to hold the loan, you should be just fine.
Hi Mark, I am looking to purchase a few properties myself do you have any portfolio lenders you can refer?
That depends on where you live. You can email me at [email protected]
If I bought one house a year for five years I can see where the 5/30 ARM would be great for the first house since the principle will be lowered so much by the time rates potentially go up; but would you still want the ARM for next four houses since it would be longer before they get the extra money toward the principle? Also when getting the ARM, does it state the amount it can increase/decrease so you know your worst case scenario?
The amount they can go up is always states in the paperwork and upfront.
I think it depends on how long you plan to have the loans. Many time I will refinance my loans even though I keep the properties. When the ARM is up and the payment readjusts it will readjust based on the principal at that time. The payment may not be much higher.
“When the ARM is up and the payment readjusts it will readjust based on the principal at that time. The payment may not be much higher.”
Can you please explain what you mean by that?
Thank you!
Actually, after reading a few more comments here, I was able to understand that… 🙂
Another question though:
If you do a 5/30 ARM, what is the general rule these days when it comes to refinance or pre-pay-off remaining balance. Any penalties? Fees?
Depends on the lender. With my lender there are no penalties.
When you first get the loan your payment is based off the original loan amount. $100,000, but in five years you may pay off $7,000 so the new payment will be based off $93,000.
Let’s say you have 11 rentals bought for 100k each with 20% down and financed through 5/30ARMs, and they cashflow $500mo. Your principle alone is $880K but your income over 5 years is 330K minus repairs and holding costs. You’d need 15 years plus to pay just the principle.
How do you work out the math so you don’t get over extended with too much of the increased interest payment when you’re doing snowball payments?
The cash flow is after paying expenses: holding costs, maintenance, vacancies. Every month your loan is decreasing when you make payments. When the ARM could adjust at five years the loan should be paid down close to $10,000 even paying the bare minimum. When the rate adjusts they base the payment off the loan balance at the time of the adjustment. If you pay more off during that time your payment could actually be lower even with a higher rate if you paid a bunch off.
Plus I always make sure my cash flow will cover the payments even if they go up.
How do you manage to have the cash flow to pay off your loans in less than 7 years?
Buy cheap in good areas with a great rent to value ratio.
Hi Mark,
I used to live in Northern Colorado, but now I reside in Omaha. I am just at the beginning of putting my goals together to start my Long Term RE investing plan. One thing I think I am curious about is with your deals, is how do you get your Down Payments. It looks like you are approximately putting down 30k/ deal. Where are these funds coming from? THanks !
Hi Andy,
I get those funds from selling houses as a realtor and flipping houses. I did refinance a couple houses to get more funds as well.
Matt,
Adjustable Rate Mortgages – known outside the U.S.A. as variable rate mortgages – are very commonly used instruments and they are typically superior to fixed rate mortgages over the course of paying-off a property. All our residential (1-4/6) unit rental properties that are financed carry a variable rate mortgage.
In the U.S.A. you have the anomaly of long-term (15, 30-year), fixed rate mortgages which do not exist elsewhere (in Canada, most mortgages are 5-yr terms). Aimed primarily at owner occupants, they promote a set-and-forget mindset, even if the interest paid is substantially higher over the long haul. When you are running a business, set-and-forget, might not be the best approach to your goals and {most times} will cost you more in the long haul.
In certain situations – viz. If you were certain we were about to see a repeat of 1979 – 1986 – locking in for 15 or 30 years would be a good thing. However, in most instances it will cost you more over the life of the property financing than using sequential 5-yr variable rate mortgages.
Unfortunately most ARM offerings I have encountered in the U.S.A. are neither as simple or beneficial as a variable rate mortgage here at home (which is currently 1.5 – 2.0% lower than an equivalent term fixed rate mortgage). If they were a more frequently used option, then the market for them would be more competitive.
Roy, I have found 5/30 year ARMs to be 1% or maybe a little lower rate than the fixed equivalent. The nice thing about the US is you can us an ARM and amortize it over 30 years.
Is there additional points or fees if you convert loans to fixed when rates rise someday? What is the highest rate these arm loans will go? Do you run any risk of not being able to get new loans and stuck?
Is this example,
Mary buys house for $100,000
After 5 years Mary has 75k balance.
Mary refi 75k at fixed rate.
Now Mary has 30 more years of payments instead of the 25 years she originally had left?
Mind you Marys new fixed loan is at higher rates – does she run the risk of not qualifying for loan mod? I want to do arm my next purchase so checking.
Thx
Yes, you would have to qualify for the new higher payment if you were to refinance. I would not do an ARM if I had to be dependent on refinancing it after 5 years. I would have back up plans, absorb higher payment for a few years, sell house etc.
That would be true if she refinanced with another 30 year loan. She could refinance with a shorter term loan if she wanted or not refinance at all. My strategy is to pay off the loans before they adjust so it does not matter to me, but not everyone is the same.
Hi Matt,
yes i believe there would be additional costs to convert to a fixed, but I don’t plan too. I plan to have them paid off before they adjust or shortly after. I think the highest they can go for me is 8.25%. There is risk in everything we do, but I have plenty of cash flow to cover higher payments in the worst case scenario.
Hey Mark!So just to make sure I understand, you take all the cash flow from all seven of your properties and pay down the mortgage on house #1. Then when that is paid off, you take all the cash flow and start paying down the mortgage on house #2. And so on.
My strategy will be to use all of my cash flow as down payments for more rentals, so an ARM probably would not be a good idea for me, but I do like the approach. Also, does your portfolio lender let you put mortgages in your wife’s name also?
Hi Sharon, Yes that is what I do, but my problem right now is finding great rentals not money for down payments. If you need more money for down payments I think your strategy is great. My wife doesn’t have any income so she won’t qualify for a loan. But my portfolio lender does not care how many mortgages I have.