Why an Adjustable Rate Mortgage (ARM) May Not Be As Risky as you Might Think

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On the forum I see occasional people ask about the pros and cons of getting an adjustable rate mortgage (ARM) on a rental property.

Most people who respond in the forums are against ARMs at any and all costs.  People tell the poster that ARMs are too risky, because the interest rate on the ARM will go up, they could lose their job, rents could go down and ultimately the rental property will be lost to foreclosure.

I have a completely different view on ARMs; I love them!

I bought my 10th rental property in March and I used an ARM to finance it as I did with the 8 rental properties I bought before it.  One reason I use an ARM is my portfolio lender only offers ARMs or 15 year fixed loans, but even if I had the choice between an ARM and a 30 year fixed I would choose the ARM right now.

What is an ARM and What are the Terms on My Loans?

An adjustable rate mortgage is a loan that has a fixed interest rate for a given term, like five years.

The loan can be amortized over various periods of time with 30 years being the most common.  After the 5 year fixed rate term, the interest rate can rise or fall on an ARM. The interest rate on the loan can only jump up a certain percentage each year and there is a maximum the interest rate can rise as well.

On my last rental property purchase I used a 5/30 year ARM with an interest rate of 4.5%.  5/30 means the first five years of the loan are fixed at 5% and the rate can rise after that.

The interest rate was a little higher on this loan than what I normally pay because I have more than 10 mortgaged properties now.  I bought this property for just under $100,000 and my lender allows an 80% loan to value ratio.

The payment including taxes and insurance is $476 a month on this house (taxes are super low in Colorado and particularly this house).  If you are curious I have the home rented for $1,250 a month with the tenant paying all utilities.

How Much Can the Interest Rate Rise on My ARM?

The interest rate on my ARM is based on the LIBOR interest rate.

My interest rate can rise 4.25 percent higher than the current LIBOR rate, once my fixed rate term is over (five years).  However, my rate cannot rise more than 2% in any year and never go higher than 9.5% total.

Related: Are All Interest Only and Adjustable-Rate Mortgages Bad?

Right now the LIBOR rate is .53% and has actually been decreasing recently.  Here is a breakdown of the maximum rates my loan could have after my five-year fixed rate term is up.

Year 6:        6.5%   payment: $563

year 7:        8.5%   payment: $685

year 8:        9.5%   payment: $702

It is important to remember this is the most the rate can rise if the LIBOR rate increase significantly from where it is now.  The LIBOR rate has been much higher in the past than where it is now so it is possible that the maximum rates could come into play.

What Would My Rate Be if I Used a 30 Year Fixed Loan?

I don’t know!

My portfolio lender doesn’t offer a 30 year fixed rate loan and it would be very difficult for me to get a mortgage with most lenders since I already have ten mortgages.  I can estimate what my interest rate would be if my portfolio lender did offer a 30 year fixed loan.  The current interest rates on a 30 year fixed rate loan are 4.34% and the interest rate on a 5/30 ARM is 3.37%.

These are owner occupant rates, but I am only concerned with the difference between the ARM and the fixed rate loan.  The ARM is almost a full percentage point cheaper than the 30 ear fixed rate loan.  If I was paying one percentage more on the interest rate I would have a payment of $525 a month, which would be $49 more per month.

How Much Cheaper is an ARM than a Fixed Rate Mortgage?

I am assuming a lot when I make these calculations.

The biggest assumption is that I could get a 30 year fixed rate loan with ten mortgages in my name.  If I were able to get a 30 year fixed rate loan, the chances are I would put be putting much more than 20% down and my rate would be higher than 5.5%.

This example will give people with less mortgages the basic idea of how much an ARM will save them.  Over five years or 60 months, that $49 difference in mortgage payments will equal $2,940.

How Much More Will the Payment be After the Rate Adjusts?

If the ARM were to adjust to its maximum rate after five years the payment could rise $87 in the first year.

Even though the payment is 2% higher than the ARM rate, it is only 1% higher than the fixed rate.  The increased payment would only be $38 higher than the fixed rate loan.

Related: Do Adjustable Mortgage Rates (ARMs) Make Sense?

In the second year the rate could jump to 8.5% and the payment would be $209 more than the initial ARM payment and $160 more than the fixed rate payment.  In year three and beyond the payment would be $226 and $177 higher.

How Long Will it Take an ARM to Become More Expensive Than a Fixed Rate Loan?

Here is the math to see when the ARM becomes more expensive than the fixed rate loan:

Year                                                       Savings

1-5       ARM saves                           $2,940      -$2,940

6           the fixed rate saves           $456          -$2,484

7           the fixed rate saves           $1,920       -$564

8           the fixed rate saves           $2,124      $1,560

As you can see the fixed rate loan does not start to save money over the ARM until you have had the property for 8 years and a few months.  This assumes the worst case scenario and the rates are at the highest levels they can be.

Why I am Not Worried About 8 Years Into the Future

8 years into the future I could be paying a lot more for my loan than I am right now, but I don’t care.

The biggest reason I don’t care is I am paying off my ARMs before they have a chance to adjust.  I paid off my first rental just over three years after I bought it.

I plan to pay off all of my loans prior to them reaching the time frame where they could adjust.  Even if I don’t pay them off before they adjust, I am still ahead as long as I don’t hold them more than 8 years assuming rates go higher.

More reasons why I am not worried about my ARMs adjusting:

  • I have plenty of cash flow to cover an increased payment in the future and chances are rents will rise with inflation.
  • I have plenty of reserves and savings to cover a short fall if for some reason the market for sales and rentals tanks and rates increase.

Why Saving Money Now is Worth More Than Saving Money in the Future

We all know about inflation and that money is worth less in the future than it is now.

If you factor inflation into this equation (I am not doing that math), then the savings would be even great for the ARM and the break even date for the fixed rate saving money over an ARM would be even later into the future.

What Are the Situations Where an ARM Can Get You Into Trouble?

I am not saying an ARM is the best loan in every situation, but I do not think people should discount them as risky until they look at the numbers.

There are times when an ARM should not be used, because it is a recipe for disaster.

  • If you can’t qualify unless you get an ARM this is a bad sign.  That means you can’t afford the payment when it does adjust and this is how so many people got into trouble on their personal residence during the housing crisis.
  • If the terms of the ARM are very short and the rates can increase substantially more be careful.  There are/were ARM fixed rate periods as short as a year or 6 months.  If your payment can increase in a very short time period be careful.
  • If you don’t have any or enough cash flow to cover the increased payment when an ARM adjusts you are asking for trouble.

Conclusion

Don’t be afraid of an ARM because you heard they are risky.  Do the math yourself to see if an ARM will save you money and work out the best for your personal plan and goals.

Do you have an experience with an ARM working in your favor?

Be sure to leave your comments below!

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About Author

Mark is Real Estate Broker and investor in Greeley, Colorado. Mark invests in long-term SFR rental homes and also does 8-15 fix and flips a year. Mark started a blog this year that focuses on investing in long term single family rentals.

16 Comments

  1. The examples that you gave were excellent. I concur with your observation. In fact, history has indicated that those who had taken ARM have done much better of than those who had used fixed rates. I personally had many ARM in the past because I was refinancing those properties every 2 years and had done much better than the fixed rates. Yes, I also have several Fannie Mae rates which I took out 3-4 years and of course currently they are not as good as the ARM even though those rates were attractive then. I personally prefer the ARM unless I can get a low fixed rates for say 10 years at 4% and intend to keep the loans for a long time with minimal prepayment penalty.

    • Thank you Paul! I agree completely. The great thing about an ARM is it gives you flexibility. You can save the extra cash flow or do many different things with it.

  2. Mark,

    You say you have ten mortgages with ARMs. Are these mortgages tied to your name or an entity? If it is in your name, are these recourse loans?

    Thank you,

    Tony

  3. Great objective overview on ARMs Mark. There may be a typo in the first section, however:

    “On my last rental property purchase I used a 5/30 year ARM with an interest rate of 4.5%. 5/30 means the first five years of the loan are fixed at 5% and the rate can rise after that.”

    I believe the second % given should be 4.5%.

  4. Brian Levredge on

    If the objective is to pay off the mortgages on your portfolio prior to maturity, why not take a 15 year loan in the example you used? I would guess the interest rate would be the same if not better than what you get for a 5/30 ARM, with the added benefit that there is increased principal reduction. Your tenant is paying off more of the property than they otherwise would which means you don’t have to contribute as much of your own cash to pay it down.

    • James Evertson on

      My newbie guess is cash flow. If you have a 30 year am on the adjustable your monthly payment is lower. You have the luxury of paying your cashflow into the principal or holding it back should you have larger than expected capex, rising taxes/insurance, or a depression in the rental market. If one of those happen you have the cash flow to cover it; if they don’t happen pump the cash flow into the property and after 5 years your mortgage looks like it was on a 15 year am.

    • Hi Brian, I actually wrote a detailed article on why I don’t use 15 year loans over on my blog. Since the rates are virtually the same, a 15 year loan is no benefit over a 30 year ARM. I can pay more off each month if I want too, which I do. Or I can take all the extra cash flow from each of my rentals and pay off one really fast, which I also do. If I wanted to use the cash flow to buy more properties I could as well. With a 15 year loan I have no flexibility with what I do with the cash flow. With a 30 year ARM, I can use it like a 15 and I have many other options.

  5. Great article!!!!!
    I love me some ARMs! Honestly probably my biggest regret in my REI career at this point was getting 30yr fixed mortgages on a couple of early rentals. I have paid so much more money on those stupid things than on my ARMs.
    If you look at rates over the years the last time it made sense to fix you rate for more than like 3 years Carter was still in office…

    Also you were super conservative in your analysis and it STILL shows that ARMs are not so scary. Since the loan re-amortizes at the current balance at each adjustment even your worst case is like $1-3 to high. :)

    Now if you are taking a payoff the mortgage ASAP stance like you are, but don’t have extra income or other properties with cash flow to use, but are willing to put all the additional cash flow from the property into the mortgage the results are way more compelling.

    Lets use the 50% rule for expenses and when you add back the $71 escrow into that you should easily be able to put another $250/month onto the mortgage those first 5 years at the fixed 4.5%.
    With an $80K mortgage at the end of 5 years your balance is now $55,695.12. So if your rate jumps the max to 6.5% your payment does DOWN to $447 (All payments I use is adding back your $71 escrow so it is all consistent). Yup! Even with a rate increase of 2% your payment goes down since the balance is so much lower.
    So since your payment went down about $30 for the next year let’s up the extra payments to $280/month. At the end of that year the balance is $50,935.50 and if the rate goes to the new max of 8.5% the new payment is up to $486 or like $10 over the original payment. Since we are only using the cash flow we dial it back to $240/month. So at the end of that 8th year the balance is $46,941.71 and the payment will go up to $490 if the rate maxes out at 9.5%.
    This is the HIGHEST your payment will ever be, still $35 less than your estimated 30 year fixed payment.
    If you overpay or the rate goes down at any point the payment will only get lower year over year.

    Now if you did the same thing with the fixed rate to pay it off ASAP as well and made an extra $200/month (so the same payment we made each month with the ARM) at the end of the 8th year you have about $3,300 less equity and a higher payment for remaining life of the loan.
    If you continue making the same payment on both loans until they payoff the ARM should payoff a bit sooner since every payment made will have more additional principle going in and only gets bigger each year as your required payment goes down. This is assuming it stays at 9.5% the rest of the term.

    Pretty big bummer for the guy that did the “right” thing in fixing the rate and then diligently overpaid their loan every month and paid it off in about half the time. They didn’t pay it off any faster than the guy taking the “risky” loan that had things go as bad as possible with the rates. Pretty much all they got was less payment flexibility if there ever was a rough patch.

  6. Great article. I have a Google Drive account with a “financing” folder where I stockpile great ideas and tips I learn on BP. A link to your article is now in that folder. Thank you Mark!

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