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Rookie Reply: ARM vs. Fixed-Rate Mortgages (Which Is Better For Cash Flow?)

Real Estate Rookie Podcast
9 min read
Rookie Reply: ARM vs. Fixed-Rate Mortgages (Which Is Better For Cash Flow?)

This week’s question comes from Channa through Ashley’s Instagram direct messages. Channa is asking: I have three rental properties and am looking to refinance them all. Should I do an adjustable-rate portfolio loan on all three or do separate fixed-rate loans on each property? 

As real estate investors, we tend to have many different options when financing rental properties. Some, like adjustable-rate mortgages (ARMs), may come with lower closing costs and slightly lower interest rates, while fixed-rate mortgages have slightly higher interest rates but boast the added security of long-term financing for a property or properties. While both have definitive pros and cons, the implications of both types of loans must be understood before you reach the closing table.

Here are some suggestions when making the choice:

  • Understand your long-term strategy for the property and which loan works for which exit strategy
  • Run an amortization schedule on both loans to see the difference in your monthly payment
  • If you decide to go with an ARM, make sure you know what you’ll do once your low-interest rate ends
  • Calculate total closing costs to see if you have the reserves ready to go through with each loan
  • And more in the episode…

If you want Ashley and Tony to answer a real estate question, you can post in the Real Estate Rookie Facebook Group! Or, call us at the Rookie Request Line (1-888-5-ROOKIE).

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Listen to the Podcast Here

Read the Transcript Here

Ashley Care:
This is Real Estate Rookie episode 170. My name is Ashley Care, and I’m here with my co-host Tony Robinson.

Tony Robinson:
And welcome to the Real Estate Rookie podcast, where what we do is we focus on those real estate investors who are at the beginning of their journey. So maybe you’ve got no deals. Maybe you’ve got one or two and you’re looking to scale up. If, so this is the podcast for you because every week, twice a week, we bring you the inspiration information you need to get started. Ashley Care, what’s going on? How are things in your neck of the woods?

Ashley Care:
Good. So today we actually have a question from my DM. So if you want to just jump into it today, we’ll get started. I’m actually excited about this one, because this one, we got to get a little freaky in the spreadsheets as to analyzing numbers, figuring out. So let me pull up the question here. Okay. So this is from Channa Chin, and this is from my DMS on Instagram, at Wealth From Rentals, or you can send a DM to Tony at Tony J Robinson if you guys have a question that you want us to play on the podcast. She said, “Good evening, Ashley. My name is Channa Chin. I am a new real estate investor. About six months ago. I read Rich Dad, Poor Dad, and I listened to your podcast and Bigger Pockets Money podcast. Now I have bought three rental houses, four units total, and the last two houses I bought with cash and now looking for refinance and take my money back. I’ve been talking to the bank around my area. They said they can do two different options.
So option one, they can loan me on all three houses in one loan, but it would have to be a three and a half percent interest rate, a five year ARM with small closing costs. So the five year ARM means that you will have a fixed rate for five years. And that is that 3.5%. And then after five years, you’ll go to a variable rate or you can refinance to get another fixed rate. The second option is to have three separate fixed rate loan. So each property will have their own mortgage. It would be at a 3.875% and a 30 year fixed instead of just a five year fixed. So some of the differences here are the interest rate. The first one is a three and a half percent. If you do one loan, if you do the three separate ones, it’s a 3.875%”, which Tony, in my opinion, I think both of these are still pretty low.

Tony Robinson:
Yeah. Those still pretty solid rates.

Ashley Care:
Yeah. So, and then the second difference is that the first one is only fixed for five years and the second one is fixed for 30 years. Tony, do you want to kind of explain what your thoughts on the difference in having those two fixed rates?

Tony Robinson:
If we can, let’s just break down the pros and cons of each option, right? Because each option has its strengths. Option one, there’s only one loan that you have to deal with, which is nice, right? Or anyone who has multiple properties and multiple loans knows that can be a bit of a headache, so only having one loan to deal with is a good thing. The interest rate is a few basis points lower, right? 3.5 versus 3.875. So you’ll save a little bit of money on interest with the lower interest rate. The cons of the ARM are that it’s not fixed. After five years, who knows where your interest rate could be? So you’ll get a really nice interest rate of 3.5 for the first five years. And then who knows, maybe it’s four and a half, maybe it’s five. Who knows what it’ll be five years from now?
So there’s some uncertainty around what the long term cost of that loan will be. Now, for the fixed rates, the pros are that it’s a fixed rate, right? You know, for the life of that loan, as long as you don’t refinance, you’re going to be paying 3.875% for 30 years, which is good to know. The cons are that you’re paying a little bit more in interest, right? At least for those first five years. And the other con is that you have the additional closing costs, right? There’s closing costs per loan. So you’re going to spend a little bit it more money out of pocket to get those properties or to get those loans set up. So those, at a high level, I think those are the pros and cons of each. Did I miss anything Ash?

Ashley Care:
No, I don’t think so. You hit basically the big ones here is, to what to consider when you are looking at mortgage options. So what Tony and I did was we actually ran the numbers on these mortgage payments to kind of look at what they would be, and we don’t have all the option, or all of the information. We don’t know exactly what the closing costs were on each of these. We do know that the closing costs were less on the first option of only one and more for the second option of if you’re separating all three out, which is, that’s right. That’s just a viable, because you’re doing three different loans. You’re going to have three different mortgages filed. There’s three sets of paperwork for an attorney to do. So having the three separate loans definitely will increase your closing costs. So, that’s not something that’s uncommon.
So we ran an amortization calculator. So that is where you plug in how much your loan amount is for, what is the interest rate, and then also how many years is this amortized over for? So once you were on the amortization period, we did it for both of these. And so we took the first five years for the first option, and the loan payment for the month was $1,347. Then we took option two and ran it for three separate loans. And we just, we didn’t know the values, but we used $300,000, so that each house was $100,000 each, and then if we did the three separate loans at 30 years at the 3.875%, that mortgage payment came to $1,410. So monthly cash flow, that is a difference of $63. We’re doing the three separate loans would be $63 higher every month. So then we looked at the interest rate and how much interest you’d be paying over the years.
So if you did the first option, over a five year period, you’d be paying $50,704 in interest over those five years. In five years for the three separate loans, you’d be paying $56,307. So about a $5,500 difference over that timeframe. So those are the things we looked at. And then, obviously, we don’t know the closing costs. So me personally, I would go with the second option of doing the three individual loans, so that your loan payment is not going affect your cash flow that much. And if that $63 is really going to hurt your cash flow, having three properties, it’s probably not a good deal then anyways, if you’re going to be hurting off of a $63 difference.
The second thing is the interest isn’t a huge amount over five years that you’re paying extra on the loan. The thing I like is that you have that security of knowing what your interest rate is going to be for 30 years and then having it change in five years. I also like having the three different mortgage payments. So if I decided, you know what, I don’t want a $1,400 mortgage payment anymore, I want to pay off a property, I want to own a property free and clear, you can do that without really affecting your mortgage. You can also go and pay down a big lump sum on your mortgage and get a property taken off. But that’s a lot more of a process than just paying off one property and getting that mortgage taken away.

Tony Robinson:
Yeah. Lots of good points there, Ashley. I mean, I agree with you totally. If I were in her position, knowing what I know, I would probably go with that second option, having the three separate mortgages as well. And to me everything you mentioned, but the interest rates, I think are what stand out it to me the most. I actually looked it up right now while you were going through your points here, and I just want to break out what interest rates look like decade by decade, so we all kind of have a better historical context of where rates are today, because I think a lot of people are freaking out. Their rates have gone up in the last 12 months or since the beginning of the year, but historically we still have really, really low interest rates.
So in the 70s, interest rates on average were about the mid sevens, in the early seventies. They ended the seventies. So by ’79, 11.2 was the average interest rate for mortgage. In the 80s, and this is almost unbelievable, in the 80s, it had got as high as 16% people were paying for their mortgage interest rates, which is crazy. Things came down the 90s, they started the 90s off around 10% and got down to just about seven by the end of the decade. And then in the 2000s, you start seeing things fall to the fives and as it progressed in the 2010s, we got into the fours. And now we know in 2020, 2021, 3 below three for a lot of mortgages. So even though we’re higher now than where we were in 2021, we are still, from a historical context experiencing really, really low interest rates.
So for me, if my plan is to hold this property for the long term, I’m going to try and lock up this 3.85% interest rate because 30 years from now that’s going to be like free money. Almost the only reason maybe I would go with the other option, is if my plan is to liquidate all three of those properties within that first five years, right? So if you’re not planning to hold these long term, then yeah, go ahead and maximize your cash flow in the short term, pay the lower interest rate and then sell all the properties when you’re done. But if you want to hold, I would go with the option two, as well.

Ashley Care:
Yeah. That’s a great point, Tony. And you can look at it and say, okay, well, when mortgage rates were that much higher houses decreased because people couldn’t afford them and unless the sales price was cheaper, but you’re purchasing this property today. So if mortgage rates do go up, you’ve already paid that purchase price on the property. So if you’re purchasing three, five years from now and interest rates do go up or skyrocket, housing prices will probably come down or level out. But that may work out for people who are purchasing properties in that three to five year. But you’ve already paid for this property in this really hot market right now that you want to keep a low interest rate for this property to make sure that your numbers are going to work. And I just think the 30 year option would help me personally sleep at night if I’m going to hold onto this property.
Well that is today’s Rookie Reply. Thank you so much to Channa for sending in your question. If you guys want to have a question answered on the Rookie Reply, you can send us a message on Instagram at Wealth From Rentals or at Tony J Robinson, or you can call the rookie request line and be featured on our Wednesday episode is 1-888-5-rookie, and you leave us a voicemail with question. Thank you guys, and we’ll see you on Wednesday.

 

 

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.