Have One ARM in Your Loan Portfolio?

[Bryan Hancock]

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?

[Vikram C.]

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.