I'm working with two banks right now to try and finance a four-plex. Both are 20% down and amortized on a 30 year schedule. One is a fixed 30 year mortgage at 4.625% and the other is variable at 3.25% for the first 5 years. After that it can only go up or down by 2% every five years maxing out at 11.25% in 20 years worst case scenario. We are purchasing for 43k and I'd like to see it paid off within the first 5 years. We are talking $28 a month difference and over 5 years thats $1680. What are the pros and cons of either and which should I go with?
I would calculate my NOI-Reserves. I would want it to be quite a bit above my mortgage payment before I would take the variable loan. In other words, I want to be 100% sure I can pay off the loan in 5 years without having to put extra money in it.
That is a big rate difference, even though the monthly amount is not much. If you have the reserves to handle a higher payment in case you don't pay it off I would go with the ARM if it were me. Even though the ARM can adjust at 5 years, the savings in the first five years means you won't actually pay more total interest until around years 7-8. Plus money is worth more now than in the future thanks to inflation.
A 1.375% difference is enough for me to take the lower rate. However, at $28/ moth difference, don't agonize. How long do you think you'll own it?
Another thing I didn't mention is that the bank with the ARM will only allow you to have one rental financed with them at a time. That being said, my thought was to save that lower rate for a more expensive property where the difference in rates would equal more dollars per month.
@Jon Klaus I don't have a set amount of time I'd like to hold it for in mind. As long as it cash flows and isn't a pain to manage I'll hold on to it. If It makes sense to let it go and trade up at any point I could go that route too.
For myself, paying $25/mo to not have restrictions on my future financing is more than worth it. What is that compared to passing up one good deal in the next 5 years?!
I just refinanced a $400K from 3.25% to 4.5% (what!?!) to get rid of the FHA loan so I can have the ability to do one again if and when necessary. (Payments are actually the same since I had mortgage insurance, but would have rolled off in 6 years..)
@ Brandon Hall
I like the 4 5/8 % for 30years . You can always prepay , and it sounds like you will have more flexibility for the future. It might make long term planning easier as well.
30 year fixed all day. Get yourself established and pay it off ASAP.
Go with the fixed rate. How many points are you paying? $43K is a small FHA loan...
Rational vs Emotional choice:
Quick answer: Go with the Arm. Key considerations are 3.25% for 5 years, after that, for the next 5 years the worse case is that you have a 5.25%. With 10 year average of 4.25%, it's still better than the fixed rate loan of 4.625%. If in year 10 to 15 they raise it to 7.25% then you can refi or sell or even wrap the loan to another buyer. A lot of people expect rates to go up in the future. This may still be less then. Hopefully you have added value and enjoyed great cash-flow.
Considerations you need to know to help make the choice:
What net income do you expect to get?
What do you have to invest to get it going?
What deferred maintenance will you push off for 1 to 5 years (ie, do you need to change the roof in 3 or 5 years, are your water boilers 6 or 8+ years old...)
What are the area vacancy rates?
What is your ability to pay down the loan quickly if things go bad?
If things go bad, can the property's income afford the 11% worst case scenario?
What will the property resell for right now if things aren’t what you expected?
Arguments for Fixed rate loan:
It depends on your goals, situation and experience/confidence/comfort to risk. If you have low and inconsistent cash-flow, but enough for the fixed rate loan then you may want to go with the fixed rate. By cash-flow, I mean cash-flow outside of this property. Once you add leverage of any kind, you ad risk and responsibility to your life. I am a firm believer in using financing, but avoiding over leveraging.
The reason the fixed rate loan has higher interest is because the bank is assuming the risk of a long term loan with rates that will definitely go up. The arm rewards you for taking on that risk and takes a more savvy investor to take advantage of it. Taking the fixed rate loan doesn't mean that you are not savvy, it just means that you prefer to having a “Known” condition in the investment.
Arguments for Arm and paying it down in 5 years
If you have high cash-flow then you can afford to do the arm and paying it right down. This will save you some money but if it's a long term investment then it might not be the best option because until a year 15, you are saving money over the fixed rate loan.
Table of rates over the years: Years - Avg Int Rate
5 - 3.25%
Arm for 5 years
Term in Months:60
Fixed Rate for 5 years
Term in Months:60
Arm avg over 10 years. (3.25% * 5 + 5.25% * 5 )/ 10
Term in Months:120
Fixed rate for 10 years
Term in Months:120
Arm avg over 15 years (3.25% for 5 years + 5.25% for 5 Years + 7.25% for 5 years) / 15 years
Term in Months:180
Fixed rate for 15 years
Term in Months:180
We can see the savings if we pay it off, or sell it at 10 years. This will save you some money but if it's a long term investment then it might not be the best option because until a year 10, you are saving money over the fixed rate loan. Even if you go into year 15, you are doing fine.
What would Phil do and what would Nevie(my wife) think about it:
Because I don't need the income to live on, I would be more aggressive and not pay off the loan in 5 years. 4 plexs can produce incredible cash-flow, and if you don't need it to live on, you can pay down that loan really fast if you finally decide that you don't like the terms of the loan! If it were me, I would go with the arm because I would reinvest all the savings and cash-flow That rate is great, and because my rates of returns are much higher than the 3.25% to 5.25%, in 5 to 10 years I could make much more money with that 43k then paying it down in the 5 years. Then if they do start raising the rates, the 4plex should be well established and cash-flowing consistently so you can then focus on paying it off or selling it. Also, if you have reinvested all that money then you should have plenty of other assets working to pay down that loan fast. I would use the cash-flow savings to invest in marketing, options and purchases.
The key for me is that I do not live on that income. If you do live on the income, and want stability and to not invest in more properties then maybe the fixed rate loan is best for you.
Well, sorry for the short answer, but I hope it gives you something to think about.
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