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?
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.
Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
15y
I think rates will drift north a bit...who the heck knows though. The economy appears to be improving from where I sit so I anticipate a return to normal rates soon.
I wonder what The Mortgage Professor would use as an adjustment for the 1-year LIBOR. Maybe I should write him to tell him his article is missing an index ;-)
SFR Investor · Orange County, CA · Member since 2009 · 1k+ posts · 1k+ votes
15y
Originally posted by Bryan Hancock:
I think rates will drift north a bit...who the heck knows though.
They're drifting up a little now, but who can tell if it's the beginning of a true upward trend or just "noise"?
We had expected our 3.625% rate to go up by the end of 2010, but it went DOWN instead! Right now, the 1-year LIBOR would have to rise by 1.5% for our rate to match current 30 year fixed rates. Do we bite the bullet now and lock in or ride it for another year? The most it can go up a year from now is +2%, putting us at 5% for 2012 which isn't all that high either.
For now I'm just hawking the rates and keeping an itchy finger on the refi trigger. :shoot:
Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
15y
It really depends on what you are trying to do. My thought is that I want to keep a small loan as my ARM to calibrate cash flow in the event that available projects are stagnant. This hasn't ever really been the case for me, but there are other things to consider like your target leverage ratio and decreasing it over time. If you wish to decrease your leverage and strengthen your balance sheet a bit it makes sense to me to prepay the ARM instead of the FRM so that you get tangible cash flow instead of principal paydown that isn't monetized until sale time, refinance time, or when you pay the note off.
My thinking is that having a small note relative to the size of your portfolio as an ARM is that you aren't largely exposed to interest rate risk while gaining the ability to increase cash flow through debt retirement. So if your note is small I would say keep it and see what happens in the next year. If it is big and that interest rate risk is too high you may consider refinancing to a FRM and carrying the next loan as an ARM for a small property you acquire.
If there are flaws in this logic I would love to hear about them. I haven't executed this strategy yet, but I am considering doing so on my next purchase. Coupling this with a friendly second from private lenders may be a talking point for my attorney when we have lunch soon. That will protect equity some, give me prepayment cash flow options, and fit with the overall strategy we have.
Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
15y
I am not sure if they exist, but my understanding was that those used to have 10-year balloons too. I am not sure what happens on the prepayment on those notes. Do you just pay interest only on a decreased mortgage balance or does the money go into escrow and get adjusted periodically?
Investor · Newbury Park, CA · Member since 2010 · 80 posts · 19 votes
15y
Originally posted by Bryan Hancock:
I am not sure if they exist, but my understanding was that those used to have 10-year balloons too. I am not sure what happens on the prepayment on those notes. Do you just pay interest only on a decreased mortgage balance or does the money go into escrow and get adjusted periodically?
My understanding is that the loan recasts at year 10. So if you if you're only paying interest for 10 years, then you're payment is going to skyrocket. But if you're judiciously paying down the mortgage with extra prepayments, at year 10, your mortgage could go down. Sort of like a free refi at year 10 into a 20 year fixed mortgage.
Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
15y
The trouble is that those loans likely come with an interest premium too. ARMs will start out with lower payments. The right product really depends on what you are trying to do.
Investor · Newbury Park, CA · Member since 2010 · 80 posts · 19 votes
15y
Originally posted by Bryan Hancock:
The trouble is that those loans likely come with an interest premium too. ARMs will start out with lower payments. The right product really depends on what you are trying to do.
Who is doing 10-year recast IO loans right now?
I don't anyone doing this loan. My mortgage broker sure wasn't. But if this loan did exist, I'd consider it. Cause then prepaying the mortgage would have a benefit if at year 5,7,10 years by potentially improving your cash flow if that's your goal. Or if you're like me turn a negative liability into a positive one.
Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
15y
Eh...I still like the ARM scenario described personally. If the loan is only recast past year 10 you don't enjoy more cash flow from years 1-10 using the IO loan.
It is a good thought for certain scenarios though. I would be interested to learn about who is doing these loans if they still exist.
Investor · Newbury Park, CA · Member since 2010 · 80 posts · 19 votes
15y
Originally posted by Bryan Hancock:
Eh...I still like the ARM scenario described personally. If the loan is only recast past year 10 you don't enjoy more cash flow from years 1-10 using the IO loan.
It is a good thought for certain scenarios though. I would be interested to learn about who is doing these loans if they still exist.
I think the only comforting thought of this hypothetical loan is that the rate stays fixed. Who knows in 10 years inflation could be a realistic issue.
Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
15y
Well, happy new year to all.
First, had to revisit the entire thread. Lots of pure BS in here. Just to fill in for others that might be reading this, there are financial ratios that measure performance of an earning asset and the valuation of the asset, not the same thing at all. A loan constant is much like the acid test in measuring debt coverage, while it can imply performance it is not at all like the earnings per share for example. The loan constant is measuiriung the buy down of a portfolio or loan for figuring the maturity distribution of the portfolio, it is not telling you anything about quality or yield or anything to compare with any use of funds analysis.
I think Mike G did a great job in translating alot of ......into a meaningful thought and since it was affirmed, I'll go with that.
Bryan, that is a good tactic to prepay ARMs early while at the lower, or sucker, rate. After they adjust however, it may be a different story.
I had trouble understanding the very first post since it was suggesting that payments were reduced. That will only happen if principal is reduced significantly so that when the loan is reset at a higher rate (usually) it will provide a smaller payment. Many are under the assumption that a 5-1 ARM for example is on a 30 year amortization and when it resets in five years that it is re-amortized at 30 years, it is not, it is re-amortized at the remaining period or for 25 years. But the secondary market loans are only reset one time as to the amortization, and interest will be re-set at the end of the initial term and then annually. So, payments may not actually be smaller, it will dependc on the initial principal reduction.
It is very easy to design any adjustable rate mortgage to meet any scheduled reduction you like. And the expected appreciation can be used to leverage future deals, based on the pay down.
Generally, an ARM should be considered for short term held properties, dumping them prior to adjustments in interest or where rehabs can raise LTV to leverage equities established. Since there are only two ways to use equity in the walls, borrow against it or sell out taking the money. Otherwise, if the fixed rate is lower than your opportunity costs, it's best to take the fixed product.
Trying to mix an ARM into a long term portfolio could be misguided IMO, especially now since rates seem to be able to go in only one direction now.....up!
As to the indexes there is also the 5 year T-Bill. As to portfolioed lenders, there is no limit as they may index their loan to their investment portfolios, which is basically a combination of bonds and government securities, no telling what it could be, but they will estiumate it based on past performance. While secondary mortgages are originated throughout the country with the programs mentioned, in the midwest the more common seems to be the old 11 Dist. Federal Home Loan Bank Board Cost of Funds and London Inter-offer bank rate, which is more volitile especially when rates are rising that Bryan mentioned.
Bryan, good thought on paying an ARM down, but as an investor you have many more variable to consider than mom and pop homebuyer having different financial goals. Your cost of money, use of funds, and especially availability of funds needs to be considered, especially if you will be refi-ing that ARM before it adjusts. The loan ceiling will be a factor to your future cash flow analysis as interest rates will most likely go up. And, there will be costs of refinancing.
And that leads to another issue, starting an amortization all over again needs to be looked at too. While the real value of your debt will decrease over time, with inflation, your cash flow will likely be more valuable in keeping with market rate rents....at least that is generally the hopes of landlords. So, could you spin off this excess cash in the future to pay down fixed debt, sure, if that were the best use of funds at that time. IMO
Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
15y
This question is really difficult to discuss in abstract. Yeah...the loan will be amortized over 25 years with a 5/1 ARM past year 5, but each adjustment later on will decrease the payment assuming that the rate doesn't rise appreciably. For a small loan the interest rate risk won't sink you and it would help to calibrate your cash flow. That was the whole idea...may be misguided, but I can't see why based on anything posted thus far.
A non-volatile index to determine the fully-indexed rate, a small loan relative to the size of your outstanding debt, and solid prepayments in the absence of solid uses for cash would be a nice combo. I do agree that this is a very poor use of cash though. This strategy would be more useful if rates were higher than they are now. It is more of a thought exercise and less of a practical thing for an investor with rates currently so low.