Why an Adjustable Rate Mortgage (ARM) May Not Be As Risky as you Might Think
On the forum I see occasional people ask about the pros and cons of getting an adjustable rate mortgage (ARM) on a rental property.
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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.
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.
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:
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 buy properties at least 20% below value, unless the market completely collapses I can sell my houses in the future if I can’t afford the increased payment.
- 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.
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!