Are All Interest Only and Adjustable-Rate Mortgages Bad?

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Whether or not interest only and adjustable-rate mortgages are bad is as big as the great debate on whether you should leverage properties or pay down your mortgage debt.

Although advice and opinions are readily available, I’d like to share with you some facts from my own experience.

First, to provide a solid frame of reference, I think it’s a good idea to explain or define what interest-only and adjustable-rate mortgage products are and share with you a few of their pros and cons.

Adjustable-Rate Mortgage (ARM): a type of mortgage in which the interest rate due on the outstanding balance varies based on an index, such as a T-bill or a Libor index. The initial interest rate is commonly set for a certain period of time, and then it is reset periodically, often monthly or yearly.

Pros: you can qualify for more property with less income or if it’s a rental property, you can cash flow more than you normally could with a fixed-rate mortgage. There are rate caps depending on the index (an initial cap, annual cap, and lifetime cap).

Cons: the interest rate isn’t guaranteed to be consistent.

Interest Only Mortgage: a type of mortgage that, for a set term, only requires interest payments to be made (not principal payments).

Pros: interest rates remain pretty consistent throughout the term.

Cons: the interest only mortgage term won’t last indefinitely.

Also, it may be helpful to view this graph from Mortgage News Daily of mortgage interest rates since 1975 (note: view with the zoom set to “All”).

As you can see, interest rates were pretty steady for a long time, and then they jumped up real high before dropping back down gradually after 1990.  I remember becoming a realtor in 1986, and mortgage interest rates at that time were 14%. The guys training me said, “You should’ve seen it when they were 18%.” Talk about a tough time to sell.

The Birth of the Adjustable Rate Mortgage

I pretty much remember the birth of the adjustable-rate mortgage.  It came in the form of a “buy down” mortgage at first (e.g. if regular rates were 14%, a buy down mortgage was 13% the first year, 14% the second year, and then would go to 15% for year three and the remaining 27 years).  This did allow you to sell a bigger or better home to folks, who were either borderline on qualifying, a temporary transferee, or someone whose spouse was ready to finish college or training and enter the job market in the next couple of years.  But, as time went on and the money began to leave the stock market and enter the real estate market, real estate prices seemed to really be on the rise.

Then you had the Clinton Administration, who thought it would be a great idea to increase the percentage of homeownership in the US, and the rest is kind of history, as far as the advent of the numerous types of mortgage products like interest-only and adjustable-rate mortgages that were tied to everything from the Libor index to the T-bill.

So, what was really going on and how did it shake out for investors?

To be quite honest, the great debate that you see today was going on back then to (early to mid-2000s).

You’d hear advice from some mortgage brokers (the ‘salesman’ type) that you should take out a 15 year mortgage, and by the time you reach retirement, all your rentals will be paid off.  And then you’d hear some of the investor friendly mortgage advisors telling you to utilize more interest-only products, because you’ll use less capital and get a higher return on investment (as long as you’re still cash flowing with the minimum down payments).

With the money saved, now you could buy more properties and build a much larger portfolio, with more tax write offs, and the best part is that the tenants are buying all of these properties for you. Besides that, as long as you were still cash flowing, you’d experience greater appreciation in the future if and when the market goes up because you just happen to own more properties.  Let’s not forget that it was good for the investor friendly lenders too, because that meant more property sales, more loans, and more points and fees that they could make.

I did both.  Not only did I have a 10 year interest only mortgage on my primary residence and a 15 year fixed mortgage on my vacation home, I ended up with a total of 30 properties (40 units) in my name, my spouse’s name, or both of our names. I also had 11 lines of credit (HELOCS, which are adjustable 2nd mortgages with a fixed draw period).

By the mid-2000s, about half of my portfolio had fixed-rate mortgages and the other half had interest-only adjustable-rate mortgages, so you can probably guess what happened over the next eight or so years—I made a killing on the interest-only products. When the market crashed, the mortgage I regretted the most was the 15 year, high payment mortgage on my vacation home.  It hurts me to write that check every month even though my tenants are really paying for it, and I know it will be paid off in only a few more years.  I look at the lower interest rate on the 15 year mortgage loans, along with the high payment, and I know that I could’ve invested the money in a much higher yielding type of vehicle like a note or a private money deal, earning greater than 15%.

The rest of the story with my fixed-rate loans was that because I was an investor with so many mortgages, my rates were a little higher than the current rates on regular mortgages at that time. So, I ended up with fixed-rate loans between 6.5% and 8% during the three-year period that I was buying pretty heavily (2003 to 2006).  These are the loans I’ve been stuck with and can’t seem to get out of.  Although my FICO score has always been way over 700, after the crash, the mortgage brokers couldn’t do much other than a commercial blanket because of the high number of loans in my name.  Commercial loans really weren’t worth doing because of PA transfer tax, the high loan-to-value down payment requirement, higher interest rates, shorter terms, and recasting, as well as commercial insurance that’s required on the properties.

Related: The BiggerPockets Mortgage Center

What about Interest Only?

Now, my interest only loans, on the other hand, were fantastic.

Some were five-year interest-only and then adjusted and some were ten year.  The funny part was I even had five – five year interest only adjustable rate loans with Countrywide, who contacted me at one point and asked me if I wanted to extend my five-year to a 10 year interest-only adjustable-rate mortgage for just a $300 administrative fee.  Hell yeah!! I was ecstatic.  The irony to most of the ARMs I had was that I would still cash flow at the highest cap rate (just not as much).

But, I’m definitely glad that I took out these types of loans.  For the adjustable-rate mortgages that did finally reach the end of the five-year term, the payments actually dropped dramatically (e.g. I had one that went from 1450/mo. to 1050/mo.) because interest rates are so low and have remained that way for a very long time. Now, will rates begin to rise?  I believe they will, but for me, I’ve had a very, very good ride with more cash flow and write offs, and all I can hope for is that rents will start to rise as my interest rates do.

The biggest question for me will probably be do I sell or refinance? And if I do refinance, maybe this time I’ll go for the fixed rate if I believe interest rates are going to be heading up, over the next real estate cycle.

This is the question I have for BP members though…has anyone had an experience similar to mine?

Stuck in Customs

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About Author

Dave Van Horn is President at PPR The Note Co. - an operating entity that manages several funds that buy/sell/hold residential mortgages, both performing and delinquent. Dave has been in the Real Estate business for 25 years, starting out as a Realtor and contractor and moving onto everything from fix and flips to Raising Private Money.

20 Comments

  1. Dave

    When I bought my first 2 properties I had no reported income, and no credit. I got 5 year ARM’s at 6% (2.5 years ago). At the beginning I felt like I hadn’t made the best decision, but the more I thought about it and learned, I realized it was fine. The properties that I buy tend to be between 50-75k, and so most lenders wouldn’t even mess with them at less than 50k loan amount. I also cash flow very well, and at the end of the day if the market does shift, and rates go up when the rate adjusts, the mortgage amounts will be around 30k, so Ill still cash flow just fine even if the rate jumps up 2-3 points. On top of that, the relationship Ive built with the private bank allows me to pledge equity against one of the properties I own free and clear as down payment for new properties. 1 house valued at 100k gets me 4 new rentals with 0 cash out of pocket and the rates stay around 5.5% at 5 year ARM’s 15 year AM. What is your take on pledged equity loans?

    • Hi Kevin,
      Thank you for sharing your experiences regarding these types of loans.

      Typically, my equity loans are tied to one property, as I am not a big fan of giving the lender more collateral (cross-collateralization). After I saw what happened to my plumber, who almost lost his primary residence over an equity loan, I prefer to use private money to fund my acquisitions and renovations. Even though it’s a higher rate, to me it’s less risky. I tend to use my equity lines for more liquid, safer private mortgages to rehabbers or to purchase performing notes.

      Best,
      Dave

  2. I believe you hold on to the assets if you’re mortgages are at the levels you’re talking about especially if your mortgage is below 100K and you only have 7-9 years remaining. In regards to selling why would you want to lose 10% of the property value by the time you pay your marketing expenses as well as closing costs.

    Alan Greenspan the retired Federal Reserve head has stated that adjustables are good for the consumer and fixed rates are good for banks. The difference is about roughly 1 percent lower with an ARM vs a FIXED …I’m from Los Angeles ~ I believe interest only loans are the best loan product for appreciating markets such as LA (if you understand the benefits and you’re not racking up debt) because it allows you to control the asset and cash flow while the asset is appreciating.

    Most people up till 2007 were refinancing every 3-5 years. so they could have saved large amounts in refinance fees and an interest only has the dual benefit in that you don’t have to refinance in a down rate market in that it will by default re-set every 6 months typically puts you in the low 3’s at this time ~ awesome…the best levergage and the lowest rate on the planet.

    By the way the last benefit of the interest only is that if you were to pay down principal in a large on a given time you would automatically have a lower payment the following month, there is no other loan that has this feature especially a fixed loan.

    • Hi Alex,
      Thanks for pointing out some additional features and possible advantages of utilizing Interest only Adjustable Rate Mortgages. I agree that it’s extremely rare, in any market, for someone to be in a mortgage for more than 10 years. This is probably one of the reasons interest only loans appeal to me.
      Best,
      Dave

  3. Sandeep Sukhija on

    I am a big fan of ARM and interest only loans. Such loans have allowed me to accumulate much higher number of properties while providing increased cash flow. I agree that it may not be for everyone – but I do believe that for most “investors” (i.e. who typically re-invest the incremental cash flow back into the business) – these loans will come out ahead.

    The basic reason these loans come out ahead is that the fixed rate loans have a built-in “premium” for the lender to cover for the “unknown future”. And that premium is paid by the borrower. And my point is that there are numerous unknowns in future (e.g. rents, property values, economy, earthquakes, tax laws, etc. etc.) – why only single out that we need “protection” from interest rate unknown and would rather pay premium for that protection.

    I would much rather pay that premium to myself for the duration, build more equity and cash-flow, and then deal with the higher interest rates, if ever needed, with the savings for all the initial years.

    However, I do think that for someone who is buying their first or second property and really believes that he/she will hold on that for lifetime (> 15 years) – a fixed rate loan is a good choice. For most of us, so many things change within 3-7 years (sell, re-finance, etc.) – that all the premium paid is waste of money.

    Just my $0.02.

    • Dave Van Horn

      Hi Sandeep,

      Thank you for your response. I agree that built-in lender fees more than cover the “unknown future,” but unfortunately, the fixed-rate product protects the lender, more than it does the borrower, in many cases. For example, if someone doesn’t tap into their house’s equity or doesn’t utilize an interest-only ARM, and then the home loses value or is wiped in an unexpected occurrence (for example: earthquake, hurricane, tsunami, etc.) not only is their house gone, all of the money is too. I had a buddy, who had an apartment building in California. He didn’t have earthquake insurance, the earthquake hit, his apartment building got totaled, and he basically went under. But, if someone has the money (from a HELOC or from the money saved in payments) in a safe, liquid, conservative investment vehicle, the money would be better protected.

      I also agree that many of us (especially those who plan to sell, refinance, etc. in a few years) the money not tied up in principal pay-down, could be utilized for other opportunities. Therefore, there is a lost opportunity cost of paying the house down early. I think it’s very important for someone to consider their goals (in life and in investing) when choosing the best mortgage product for them.

      Best,
      Dave

    • Dave Van Horn

      Hi Lisa, thanks for the positive feedback! Unfortunately, the general public has a pretty negative view on the product, when it can have such a positive outcome if utilized correctly. Thank you for reading!
      Best,
      Dave

  4. My ARM has been great!! I guess it depends on the terms, your plans to sell, buy/hold/etc, AND the market. My term was a 3/1 at 5% in 2004 with a change each year NO more than 1%. Since 2009, it has gone down every single year and it currently at 2.25%! Even it goes up 1%, it won’t even reach 6% for at least 4 years. Not all adjustables work like that.

    • Dave Van Horn

      Hi Julie,
      Thanks for sharing! I’ve had great experiences with ARMs as well. I agree with you that there are certainly different kinds of ARMs. But, if someone still cash flows at the highest rate possible, terms may be less of an issue. If someone anticipates interest rates rising, plans to buy/hold for the long term, and never plans to refinance, then a fixed-rate mortgage may make the most sense.
      Best,
      Dave

  5. Sara Cunningham on

    Interesting article. Being British when we purchased our first house there interest only mortgages where the norm. You paid interest only over say 20 to 30 years. However the product was tied to an endowment policy which over the period of the mortgage would hopefully grow and when that period ended You could then cash it in and not only pay off the original loan but have cash over. Of course I am talking over 20 years ago and things have changed with the way the markets have behaved. We currently have an ARM on our biggest rental (property value $315,000) but have 15 year fixed rates on all our other properties we rent. Having said that we will actually have paid off the 15 year loan in a 7 year period.

    My question to you is this, when the interest only period ends how do you plan on paying back the loan. It would be good to see some information on how to tackle this when it happens. I totally agree with the principal of using that money during the interest only period to invest in other properties. It has to used for this though or I don’t see the advantage. However it still comes down to looking every few years as to whether to sell, refinance or pay off the balance. That to me is the toughest part.

    • Hi Sara,
      Thanks for reaching out. In regard to your question, when the interest only period ends, my goal isn’t necessarily to pay down the loan (although I always remain current). I prefer to have my house and properties paid off on a balance sheet as opposed to reality. I actually described this concept in my last article, “Who’s Your Financial Advisor?” The money saved due to the lower payments of an Interest-only ARM or the capital available from a HELOC can be placed in a safe, conservative, and liquid investment vehicle that builds tax-free or tax-deferred. This money could be accessed in the event that it’s needed. This person would be able to keep the larger mortgage interest tax-deduction by not paying the money down. The money would be protected from creditors, lawsuits, and bankruptcy. It would also pass favorably to heirs and avoid probate in the event of death. I also choose to refinance as much as possible, and to keep that money (equity) liquid and yielding a return.
      I hope some of this helps!
      Best,
      Dave

      • Sara Cunningham on

        Dave thank you for explaining this further to me. I will read the previous article you mentioned also.I totally understand the concept. I think I need to do some reading to get better ideas on how to invest the extra money you save by using an interest only ARM. I am learning so many things from here every day and have already put some of the ideas to use. Even though we bought our first property in 2006 I sometimes still feel like a complete novice. I am now in a position financially where I can devote all my time to investing while my husband works so I guess we have some things right along the way.

        • Dave Van Horn

          Hi Sara,
          It seems that you’re headed in the right direction. In regards to reading materials, you might enjoy “Missed Fortune 101” by Douglas Andrews. I’ve read it several times, and I still re-read it. It’s definitely a mind shift for many Real Estate investors, and it shares some pretty valuable ideas. Another good one is “Who Took My Money?” by Robert Kiyosaki. I hope this helps!
          All the best,
          Dave

      • Dave, that’s such a poignant post above. I also will only “pay off” a property on a balance sheet. Paying off a property in reality diminishes one’s:

        1) Safety
        2) Liquidity
        3) Rate Of Return

        Interest-only loans at a long-term fixed rate are a favorite.

        In general and in simple terms: if it makes no sense to pay extra toward the principal on a traditional 30-year fixed amortizing loan, then it makes sense to use an interest-only loan and pay nothing toward the principal!

  6. great article! I have 8 ARMs in my name now and I love them! Plus with that many loan an ARM is all I can get unless I go with a 15 year fixed. Like you said with the 15 year the payments are so much higher it kills cash flow.

  7. I love this article.
    It is great to hear someone present the actual truth about ARMs and how they have actually worked in the real world over a LONG span of time.
    I actually had a thread on this topic a few weeks ago when I had an ARM adjust down for the 3rd year in a row since the fixed period ended.
    http://www.biggerpockets.com/forums/49/topics/112401-adjustable-rate-mortgage-haters

    If you look at the facts the last time it really made a lot of sense to fix your loan was like the late 1970s right before the big spike back then (rates didn’t go back to 1977 levels again until like 1992). But for at least 33 years a fixed rate mortgage has been a loser.
    http://www.freddiemac.com/pmms/pmms30.htm

    The idea of the safe 30 year fixed mortgage is a great idea which is totally disproven by the actual facts.

    • Dave Van Horn

      Hi Shaun,
      Thanks for your positive feedback! I agree that this angle is not represented enough, and I’m glad to see you have a forum discussion on the topic. I do think that if investors utilize mortgages as a tool and choose the type that best suits their goals (instead of simply choosing the product that is sold the most) it could really go a long way.
      Best,
      Dave

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