Have One ARM in Your Loan Portfolio?

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Have One ARM in Your Loan Portfolio?

Bryan Hancock
Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes

A few years back I was studying mortgage products and learning what other options are available for debt. One of the things that intrigued me was that ARMs can have payments lowered if you prepay the mortgage. I found this fascinating because it seemed like a much more tangible benefit than prepaying a FRM where the benefit of prepayment wouldn't be realized until either sale time or the time when the mortgage was completely paid off.

I am a big believer in FRM product and specifically 30-yr debt. One of the big reasons for this is that I think the government is going to monetize the debt by inflating our currency in the long run. Consequently, it is good to have fixed-rate debt that isn't subject to interest rate movement or callable because due-on-sale clauses are enforceable.

However, it seems that picking one property out of your portfolio with a suitable ARM is a good thing so that you can slowly increase cash flow over time if this is desirable. Prepayment can be used to marginally increase cash flow if that is the right use of funds at the time.

Ideas? If this makes sense what ARM products would be the best to procure? Something with a lifetime cap, a small spread for the fully-indexed rate, and a stable index (MTA?) would seem to fit the best. Thoughts?

Which property in your portfolio would you pick to do this with if the strategy makes sense? The one with the lowest debt balance? The one with the worst fixed-rate note? Ideas?

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Vikram C.
Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes
16y

Although I do not have much experience as a borrower, here's how I look at it.

1. I would never lend at fixed rates or buy long term bonds. The corrolary is that I would also prefer borrowing at fixed rates instead of adjustable rates. A fixed rate loan is a lousy deal for the lender if the loan is for a long term and there are positive inflation surprises.

2. You do benefit from prepaying a fixed rate loan because more of your future payments go towards your equity instead of interest.

3. I do see your point regarding cash flows though. For every dollar in prepayment, how much does your ARM payment go down on a typical loan? Is it worth the negative cash flow on day 1 to get a positive cash flow over time? Unless your opportunity cost of capital is less than the ARM interest, I suspect the numbers won't add up. But please give me an example if you think I am mistaken in my conclusions.

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  • Vikram C.
    Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes
    16y

    Although I do not have much experience as a borrower, here's how I look at it.

    1. I would never lend at fixed rates or buy long term bonds. The corrolary is that I would also prefer borrowing at fixed rates instead of adjustable rates. A fixed rate loan is a lousy deal for the lender if the loan is for a long term and there are positive inflation surprises.

    2. You do benefit from prepaying a fixed rate loan because more of your future payments go towards your equity instead of interest.

    3. I do see your point regarding cash flows though. For every dollar in prepayment, how much does your ARM payment go down on a typical loan? Is it worth the negative cash flow on day 1 to get a positive cash flow over time? Unless your opportunity cost of capital is less than the ARM interest, I suspect the numbers won't add up. But please give me an example if you think I am mistaken in my conclusions.

    5Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    16y

    I agree with the spirit of your points 1 and 2 Vikram. The question about point 2 is whether or not you would rather have a paper net worth gain because of additional amortization of the loan or increased cash flow because the one loan you are prepaying kicks off additional cash flow.

    My goal is to increase passive income from my portfolio properties over time. If I get appreciation....great...but I don't make purchasing decisions at all based on upside. I make them based on trying to optimize passive income. Since this is my goal it seems having one ARM is a good idea. Sure...it isn't the best from a ROE standpoint, but that isn't really my main concern either. I want to decrease leverage as I age and increase passive income.

    Regarding point 3...it really depends. Prepayment siphons off the loan balance, the duration is held constant (decreases every month....360, 359, 358, etc.), and the payments are what decrease from the pay down of debt. You would have to go through the mortgage math to see how much it decreases the payment. The tradeoff is that the interest rate risk is transferred from the lender to the borrower for this particular loan. However, if this is only one loan among many it won't matter a whole lot. You can also cap the loan if you get the right product so that spiked inflation and rates won't put you in the poor house.

    My question is...What loan product would work the best for this type of scenario? A 5/1 ARM would reset each year. I would rather have something that resets monthly given that I plan to prepay things. Or...I could hold the cash all year and if I couldn't deploy it to more profitable projects I may use some percentage of the cash to prepay the 5/1 ARM as a fall back plan.

    Oh...and you are close to right about the cost of capital. The correct measure to compare it to is the loan constant and not the coupon rate. Fully-amortizing loans have a loan constant different than the coupon rate because you have to pay the loan back in addition to the interest.

    Other thoughts? Ideas?

    1Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    16y

    Here is a discussion of prepaying ARMs if it helps:

    Can I Pay Off an Adjustable Rate Mortgage Early?

    1Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    16y
    Originally posted by Vikram C.:
    Unless your opportunity cost of capital is less than the ARM interest, I suspect the numbers won't add up. But please give me an example if you think I am mistaken in my conclusions.


    I thought about this some more tonight and I think you are right about this. The debt constant only matters with respect to positive cash flow, but you would just need to beat the coupon rate for it to make sense to deploy cash to the mortgage if you compare this option with others. :oops:
    2Reply
  • Mitch Kronowit
    SFR Investor · Orange County, CA · Member since 2009 · 1k+ posts · 1k+ votes
    16y

    We only have one ARM and it's on our primary residence. YIKES!!! Yes, I know.

    However, with the LIBOR in the sewer, we are currently enjoying a 3.625% rate that won't adjust until the end of the year (and then it can only go up a max of 2% for another year).

    So, yeah, I'm hawking the interest rate reports on a weekly basis, if not more often, waiting for the skyrocket to take off. But, then again, I just read how the M3 money supply has been falling the last several months and the M2 is flat. Hmmm, WHERE is the inflation?

    1Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    16y

    This is a great read for picking the right index to tie your FIR to:

    Which ARM Index Is The Best?

    COFI, 12MTA, and t-bills (12 months or shorter) are the least volatile.

    I am thinking about refinancing one of my portfolio properties to an ARM tied to one of these indices with a small spread for the FIR and a low cap rate. This will allow me to increase cash flow with prepayment if there aren't any projects that make sense to deploy cash to at some set time in the year.

    Is this a bad idea?

    1Reply
  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    16y

    Hi say, would you mind Bryan defining what you mean by the coupon rate of a mortgage and how that is a concern to a borrower? The reason I ask is that the coupon rate is generally a half point lower than the note rate or street rate that goes to the servicing expenses of the loan. It is already built into the margin over the life of the loan.

    And the loan constant is the principal and interest required to cover the debt service annually, so it only applies to a positive cash flow???

    1Reply
  • Account Closed
    Landlord · Seattle, WA · Member since 2010 · 3k+ posts · 1k+ votes
    16y

    I'm considering an ARM for an investment property that I will be selling in less than two years. Pulling the money out now to purchase a property, but long term want to 1031 out of the property.

    2Reply
  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    16y

    And, the COFI is my favorite index. The term depends on the use of the property, how long is it to be held, matching the terms. The 5-1 has bene the post popular in my area and one that I made most often, besides the 30 yr fixed, which tops the list.

    IMO, there is nothing wrong with having adjustable rate debt, so long as you are in a position to pass that increase, to the ceiling, along to ther other buyer or tenant. This is not always possible with rent controls at various stages or increase limitations. Fixed rates are much easier to manage.

    Something too, which portfolio are we talking about, as a note holder or as a borrower? Bryan pointed out the transfer of risk assessments and these may be limited by the floor and ceiling, so if you can go to the ceiling rate and still have your positive cash flow in a property held, the upside is inflation, paying in cheaper dollars and property appreciation, but since your fixed products are at least 200/250 basis points below any current product's ceiling rate (with the annual adjustment limitation considered) I'd opt for the fixed. OTH, if you plan on holding for five years or less, match that to the 11th dist. adjustable loan and historically, you beat the fixed rate product...
    Another issue, if you are an option seller or wrapper (lol) you'll have far less to fear with any adjustable rate than a fixed rate with your due on sale clause. But when doing wraps with an adjustable, you need to be more sphosticated in your note to ensure that your margin is above that of the underlying mortgage and can adjust as necessary....which is a real pain for many small investor/lenders.

    The type of mortgage you use in your portfolio, as a borrower, should be matched to the use of the property and it's capacity. That might be one loan, it could be with all loans....how your structure your deals and your strategy should determine the best financing vehicle, how they cash flow and how properties and loans can be matched. In an ideal situation, your maturity distribution should be matched closely to the intended holding period of a property, that saves alot of money and headaches. Bill

    1Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    16y

    When I think coupon rate I think of bonds:

    Coupon Rate Definition To Me

    I am sure there are other parasites that extract yield spread and such for a mortgage. The annuity is also structured with monthly payments instead of bi-annual payments like what is characteristic of bonds. We can split hairs about lexicon. I am not sure if my definition jives with the according to Hoyle definition in the mortgage industry and I don't really care.

    The coupon rate using my definition is the rate stated on the note. Not all notes have servicers. A case in point is private notes, which we use frequently in our portfolio because they can be obtained on terms more favorable than what a borrower gets borrowing from professional lenders like banks.

    From the perspective of a resource deployment (using cash) the borrower would need to justify that the cash value exceed the coupon rate and not the loan constant. Vikram was correct about this after I thought about it some more.

    If you are talking cash flow then the loan constant is what matters because you actually have to service the debt and the principal repayment.

    None of this really matters a whole lot from the perspective of my original question, but it is certainly interesting to chat about ;-)

    Caveat...I am in a hurry to close write a contract so I didn't edit the post above much....could contain stuff that is confusing.

    1Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    16y
    Originally posted by Financexaminer:
    Something too, which portfolio are we talking about, as a note holder or as a borrower?

    As a borrower for long-term buy-and-hold assets....no wraps

    Originally posted by Financexaminer:

    OTH, if you plan on holding for five years or less, match that to the 11th dist. adjustable loan and historically, you beat
    the fixed rate product...

    It is impossible to know which product is better from a borrowing standpoint because you do not know what will happen to interest rates.

    The original point of this thread was to see whether or not the cash flow increase from the reduced payment from a prepayment (say that three times fast!) is worth the rise from the ceiling on the ARM...above what it would be for fixed-rate debt in the current market. The prepayment of the ARM will reduce your monthly debt service instead of reducing the term on your loan...which may be a decent strategy for one loan in your portfolio.

    Ideas? If this makes sense which loan would be the best one to pick? The biggest rate? The smallest loan?

    1Reply
  • Vikram C.
    Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes
    16y
    Originally posted by Bryan Hancock:
    The prepayment of the ARM will reduce your monthly debt service instead of reducing the term on your loan...which may be a decent strategy for one loan in your portfolio.
    . . .
    Ideas? If this makes sense which loan would be the best one to pick?


    Bryan, the idea is not worth pursuing, in my opinion. In order to profit from a prepayment of an ARM, you will need to have no other investment opportunities that give you higher returns than the ARM interest rate. If that were the case, then you should retire from investing.

    Think about the financial effect of a prepayment of an ARM. It is the equivalent of YOU lending to the bank an amount equal to the prepayment, with the bank paying you back over the amortization period based on the ARM interest rate. None of us here on BP would be willing to lend to the bank at current interest rates. I cannot imagine a lousier use of money.

    On the other hand, if you are old and plan to stop investing, then prepaying a loan can be worth it to reduce leverage. It may also be better than money sitting in a checking account.

    3Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    16y

    I don't think I would use it much, but it would help to calibrate leverage some. Prepayment would yield cash flow instead of a decreased horizon for the loan.

    I agree that it is a lousy use of cash though.

    1Reply
  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    16y

    Did you all hear about the banning of K-2, the synthetic pot? Kids (and I guess adults) are smoking to get high! They were selling this synthetic grass in stores all over the area and now the authorities are having it banned as quickly as they can. They say it has the same affects as pot....I don't use the stuff, so I wouldn't know....but they say it makes you use words that are not appropriate to situations, that it will make you unable to relate abstract concepts to reality and feelings of self-glorification. It's followed by slight depression and episodes of rage and lashing out, especially at authority figures or those who disagree or find fault with them. The long term effects just are not known. It seems to be very popular with high school kids, but the college age kids and even young adults are the main consumers. This is not just some slum drug either, it's popular amoung young professionals as well.

    I don't know what made me think of that, perhaps I just tried to hard to figure out how paying off my mortgage was like making the bank a market rate loan or paying off my loan was a poor use of my money. .hmmmm? lol Have a great and safe 4th.....the GKs want to go back out in the boat, nothing like a good fireworks display over the lake...Bill

    1Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    16y

    Whether or not it is a "poor" use of money depends on your target leverage ratio and your alternatives to invest cash.

    One of my goals is to reduce my leverage ratio as I age. This requires either:

    1. Paying down debt
    2. Buying better projects that have lower leverage ratios

    From here forward I plan to have strictly non-recourse debt in my portfolio via MFDs that are syndicated transactions. My resi portfolio will either be phased out or deleveraged over time.

    "Investing" in prepaying your mortgage is a lousy use of cash with interest rates so low. The leverage ratios need to be balanced with your ROE over time according to your strategy.

    If you plan to prepay your mortgage I think prepaying an ARM is a better use of cash because it increases your cash flow for the cash invested. If anyone disagrees with this I would love to have them play devil's advocate.

    1Reply
  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    16y

    Now, that restored my faith in young people! No disagreement here Bryan, that makes sence, as your goal! Good luck with it.....still killing time before everyone is ready, be safe all....Bill

    0Reply
  • Vikram C.
    Real Estate Investor · Phoenix, AZ · Member since 2009 · 1k+ posts · 1k+ votes
    16y
    Originally posted by Financexaminer:
    I don't know what made me think of that, perhaps I just tried to hard to figure out how paying off my mortgage was like making the bank a market rate loan


    It is fairly obvious, actually, so perhaps you can ask someone you know who understands mortgages to explain it to you?
    1Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    16y
    Originally posted by Vikram C.:
    Originally posted by Financexaminer:
    I don't know what made me think of that, perhaps I just tried to hard to figure out how paying off my mortgage was like making the bank a market rate loan


    It is fairly obvious, actually, so perhaps you can ask someone you know who understands mortgages to explain it to you?


    :mrgreen:
    0Reply
  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    16y
    Originally posted by Vikram C.:
    Originally posted by Financexaminer:
    I don't know what made me think of that, perhaps I just tried to hard to figure out how paying off my mortgage was like making the bank a market rate loan


    It is fairly obvious, actually, so perhaps you can ask someone you know who understands mortgages to explain it to you?


    There are some NEW loan programs out that I may not be familiar with, since to date there are hundreds of variations. And, after examining, originating, processing, underwriting and developing mortgages, I don't claim to know everthing about all mortgages. After having taught at the college level various subjects, to include economics, finance, accounting and real estate, I doubt I will feel lost in such subjects with anyone here on BP. But, those mortgages all have one thing in common, they must be repaid.

    As to anyone explaining to me much of anything at all about mortgages, you'll be hard pressed to find that person. It certainly won't come from anyone in this thread. Your point of a micro concept of the volocity of money fails to consider the origination of the debt and the time value of money and future unknow economic conditions underwhich payments are made, it's just ridiculous.

    Why not have two ARMs in your portfolio? Do you have a personal portfolio?

    Good luck and be safe this weekend! .



    0Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    16y

    I'd comment Bill, but it isn't worth the effort. Please direct your disdain at the people that scorned you in this thread. All I did was to post a smiley.

    If you have a problem with posts please address it for each post and people can decide for themselves who they agree with.

    0Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    16y

    I see that you changed your entire post via the edit feature Bill. My post above was in response to the previous post before editing.

    If you have a problem with me please send me a PM or feel free to keep your opinions to yourself.

    0Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    15y

    I wanted to bump this thread to see if any of our new BP members or others that happen to notice it have additional opinions.

    0Reply
  • Mike G.
    Rehabber / Flipper · Simi Valley, CA · Member since 2010 · 597 posts · 259 votes
    15y

    Hi, Bryan. I'm not sure I fully understand a lot of the details of what has been said in this thread, which is part of the reason why I don't currently own any rental properties. Anyway, I hope you don't mind if I ask you a question about your original question.

    Are you saying that you would have multiple properties, each with a fixed rate mortgage, and then have one property with an adjustable rate mortgage, and then you would take money made from the FRM properties (or from anywhere else, really) and apply additional principal payments to the ARM property while it still has a lower interest rate so that you can pay it off more quickly than you otherwise would be able to do if it was a fixed rate property, thereby having more of its income as cash flow? (Jeez, sorry for the long sentence there.)

    0Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    15y

    Sort of...the money that is used to prepay the ARM with or without an adjustment causes the payments to go down when the note adjusts. Prepaying a fixed-rate note decreases the duration instead of the payment. Prepaying an ARM decreases the payment to keep the term level.

    0Reply
  • Mike G.
    Rehabber / Flipper · Simi Valley, CA · Member since 2010 · 597 posts · 259 votes
    15y

    Oh, that's cool. I've not actually looked into an ARM myself, but now I see why you were considering it.

    0Reply
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