Are All Interest Only and Adjustable-Rate Mortgages Bad?
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.
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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?