|Every client and every situation is different and therefore may require a different strategy when it comes to financing an investment property. How long you plan to own a property, your exit strategy, current interest rate environments and your personal comfort level all play a part in the decision as to what type of loan makes the most sense. The most common choices: Fixed Rate mortgages
Adjustable Rate Mortgages (ARM’s)
Option Arm Loans
Fixed Rate Mortgages
This traditional type of loan maintains its original interest rate throughout the entire life of the loan. Any change in monthly loan payments will be due to increases in other charges like insurance or taxes that will naturally occur over time. Fluctuations in market rates over the term of your loan won’t have any impact on the amount of interest you pay because that rate is already “fixed.”
A Fixed Rate Mortgage loan may be a good choice if:
You like the security of knowing your interest rate will never change
You like the security of knowing your interest rate will never change
You plan to eventually pay the loan in full
You do not expect a significant gain in appreciation
You do not expect to raise rents
At the time you take out the loan, interest rates are very low
Fixed rate mortgages typically come in 15, 20, and 30 year terms. In determining the length of your loan you may want to consider:
The total amount of interest you to pay over the course of your loan. For example, the total cost of a 30-year loan is higher than the total cost of a 15 or 20 year loan. You are trading lower monthly payments for a greater number of monthly payments and additional interest charges.
Your ability to make a higher monthly payment. If you can afford to pay more per month you reduce the number of months you have to pay. Choosing a 15 or 20 year term will save you thousands in interest charges vs. the typical 30 years.
Another option to shorten the loan term and decrease the amount of interest you pay is to simply take out a 30 year mortgage so you don’t lock yourself into higher monthly payments, and pay extra each month towards the principal. This can be accomplished through what‚Äôs known as a bi-weekly payment plan.
Adjustable Rate Mortgages (ARM’s)
Possibly one of the most popular, yet misunderstood forms of alternate financing is the adjustable rate mortgage. Usually referred to as an ARM, its popularity with borrowers is due to a lower interest rate than a fixed rate loan. It is popular with the lenders because the ARM shifts the risk of interest rate fluctuations to the borrower.
Although many borrowers would rather have the security of a fixed rate loan provided the rate is not too high, the ARM has maintained its popularity in the market despite competitively priced mortgage loan rates.
An ARM is a loan that allows the lender to adjust the interest rate so it reflects fluctuations in the cost of money more accurately. However, with an ARM, the borrower is the one who is affected by interest rate movements, not the lender. If interest rates raise, the borrowers payments also go up If the rates fall, the borrower’s monthly payments will drop along with the declining rates.
How an ARM works
The borrower’s interest rate is determined by the cost of money at the time the loan is made. The rate is tied to a recognized index your lender is currently using for this loan.¬†Your future interest adjustments are then based on the upward or downward movements of this index.
To insure that the expenses of administration and profit are included in the payments to the lender, it is necessary for the lender to add a margin to the index. Different lenders use different margins which explain the variation in interest rates offered for the same loan program. Margins range from 2% to 4% and are added to the index to come up with the interest rate you pay (margin + index = interest rate). It’s the fluctuation of the index rate that causes the borrowers interest rate to increase or decrease.
Elements of an ARM
Rate adjustment period
Interest rate cap
Negative amortization cap
The index is the adjustable portion of the interest rate. There are many indexes lenders use including the Prime Rate, LIBOR ( London Inter Bank Offering Rates), MTA (12-Month Treasury Average), COFI (11th District Cost of Funds Index), CODI (Certificate of Deposit Index) and the COSI (Cost of Savings Index).
The margin is the fixed portion of the interest rate. It is the number of percentage points the lender adds to the index rate to calculate the ARM interest rate at each adjustment. Typically, higher risk loans to the lender will result in higher margins.
Rate Adjustment Period
The borrower’s interest rates on an adjustable-rate mortgage are allowed to be adjusted at certain intervals during the loan term. Depending on the type of adjustable loan you have, this interval could be one month, six months, one year, three years, five years or more.
Interest Rate Cap
There are limits on just how much your payments can go up if you have an ARM. Usually these caps are in the form of interest rate caps and/or payment caps. An interest rate cap determines the maximum number of percentage points your interest can increase over the life of the loan.
Negative Amortization Caps
A negative amortization cap limits the amount of negative amortization that can be reached on a loan. When the cap is reached, the loan is re-amortized to a level sufficient to pay off the loan over the remaining term of the loan. Depending on the lender, the negative amortization cap is usually between 110% and 125% of the original loan amount.
Option Arm Loans
The Option ARM loan is used by many Real Estate investors to maximize cash flow and take advantage of leveraging the most equity from appreciating properties. This loan is not for everyone or every situation, but used properly can a powerful tool. Option ARM loans allow for a very low minimum payment resulting in “Deferred Interest” or “Negative Amortization”. This low payment although causing negative amortization creates maximum cash flow and provides investors the opportunity to own properties they may not otherwise be able to own. The interest you defer is money you keep in your pocket to invest elsewhere instead of giving it to the bank.
Although each lender has their own guidelines and specific niches, the basic concept of the Option ARM loan is the same.
It allows you to choose from several different payment options each and every month.
It gives you the ability to make a very low minimum payment which allows for maximum cash flow.
It allows you to defer a portion of the interest.
It lets you choose your index. All adjustable rate mortgages are tied to some type of index. Most common are the MTA (Monthly Treasury Average), COSI (Cost of Savings Index), and the CODI (Certificate of Deposit Index).
It works perfect for both owner occupied properties or non owner occupied investment properties.
You can qualify using either full documentation, meaning we prove income and assets, or stated income/verified assets meaning we state your income and prove assets.
The most important aspect of this loan is that you now have options. You can choose to make the;
Minimum payment, or deferred interest payment.
The interest only payment.
The Principal and Interest payment amortized over either 30 years.
The Principal and Interest payment amortized over either 15 years.
The Option ARM loan gives you the flexibility to choose from any of these payment options each and every month. You may want to make the principal and interest, or the interest only payments so long as the property is rented, then opt for the minimum payment in the event of a vacancy. Or, you may decide to make nothing but the minimum payment for maximum cash flow. Either way you are in control, not your mortgage company. Your mortgage becomes a tool, not just an obligation.
The key ingredient to this loan is that it allows you the option to make a very low minimum payment. The minimum payment is calculated using a start rate as low as 1% for owner occupied properties and 1.375% for non owner occupied.
Minimum Payment Increases
Keep in mind the minimum payment is a deferred interest payment and obviously the lender will only allow you to defer so much interest. Therefore, built into the program is a gradual increase in the minimum payment over the first five years to limit the amount of deferred interest and guard against any increases in interest rates. Each year the minimum payment will increase by 7.5% of the previous year’s minimum payment. Your payments are set for the first five years so you know, based on your rents other expenses, exactly what your cash flow will be.
Fully indexed Rate
The fully indexed rate is the actual interest rate used to calculate the principal and interest, and therefore the interest due, or “Interest Only” payment each month. The fully indexed rate is made up of two parts. The margin, which is fixed for the life of the loan, and the index, which is a adjusted monthly and based most commonly on the MTA, CODI, or COSI indexes. The margin is determined by how you are qualifying for the loan. If you are purchasing a single family primary residence with 20% down, proving income and assets, and have a credit score of 780, you will have the very lowest margin. If you are purchasing a 4 unit investment property with 10% down, stating income and have a credit score of 640, you will have a higher margin. It’s very simple, since the margin is the “fixed” part of the rate, the higher the risk, the higher the margin. If the margin is 3.0% and the current index of lets say the MTA is 4.0 %, you would add those two together and your fully indexed rate would be 7.0%. This is the interest rate that determines the amount of interest due, or “Interest Only” payment on your mortgage.
Minimum Payment vs. Fully indexed Rate
Because the index is adjusted monthly, your fully indexed rate, and therefore the interest due, can move up or down on a monthly basis. The minimum payment is locked with this gradual increase, but the interest due can change. This means if you make the minimum payment and the fully indexed rate goes up, you will defer more interest. If the fully indexed rate goes down, you will defer less interest.
The best part the Option ARM loan is it allows you to defer interest. That means you have the option of paying less than the interest due, and the lender will allow you to defer part of the interest to the end of the loan. This is also known as Negative amortization. The first time you hear this you may ask, why in the world would I want to wake up tomorrow and owe more on my mortgage than I do today? Let’s think about it. Either way you still owe all the interest. Whether you pay it this month, next month, next year, or 5 years from now, you have to pay it. The Option ARM simply allows you to defer as much interest as possible for as long as possible and use that money to make more money. You will receive a statement each month and among other things it will tell you how much interest you have deferred loan to date. You have the option to pay off any deferred interest at any time, or add it to the end of the loan. When the time comes to sell or refinance you will have less equity in the property, but you’ve kept the money in your pocket, and had it available to invest elsewhere. In a sense, it’s like leveraging equity from your property on a monthly basis in the form of increased cash flow instead of waiting for some time in the future when you will leverage it by selling or refinancing. This is especially important when purchasing property in high appreciating areas that may be difficult to cash flow. Let’s face it, how much property can you afford to own when you have no cash flow. This provides you the tool, or resource to manage your cash flow, or working capital, and own more real estate.
So What Happens after 5 Years?
After year five you have 3 choices. You can allow the loan to do what is called recast, you can refinance the loan, or you may opt at that time to sell the property.
Recast means the loan will convert to a principal and interest payment amortized over the remaining 25 years. The interest rate will be a monthly adjustable rate based on margin plus the chosen index. You no longer have the interest only, or the minimum payment options. Rarely does anyone allow the loan to recast.
By year 5 you will most likely want to refinance the loan to consolidate a first and 2 nd mortgage and lower your payment, or pull cash out to buy more property. You can even refinance right back into another Option ARM if you want and start over with the year one minimum payment again.
Another option of course would be selling the property. If you have a perfectly good property that is appreciating and generating cash flow you’ll probably want to keep it and leverage your equity to buy more. However, if it’s not, you may consider selling and purchasing something else.
Subordinate financing is used when investors wish to finance higher than 80% of the appraised value of a property and avoid paying private mortgage insurance. Financing to 90% combined loan to value (CLTV) would require use of what’s known as an 80/10, meaning 80% of the value is financed with a first mortgage and 10% of the value is financed with a second mortgage. Subordinate financing is a useful tool for investors to preserve available assets to be used for down payments, closing costs and reserve accounts associated with real estate investing. Subordinate financing will most often be in the form of a HELOC (Home Equity Line of Credit) or a fixed rate second mortgage.
HELOC (Home Equity Line of Credit)
A HELOC is a line of credit secured by the Real Estate and generally tied to the current prime rate index. Your actual rate of interest is calculated using prime plus or minus a fixed margin. For example if you rate is prime plus 1% and prime is currently at 7.5%, your rate would be 8.5%. Your interest rate will adjust up or down with the prime rate and your payment is based on the total amount of interest due each month. A HELOC works much the same as a credit card in that you may pay more that the interest due to pay down the balance and maintain an available line of credit to draw on in the future.
Fixed rate second
Fixed rate seconds work more like a traditional mortgage loan and may or may not have an option of an interest only payment. The most common fixed rate second is called a 30/15, meaning the loan is amortized over 30 years with a balloon payment due in 15 years. In most cases investors will refinance long before the 15 year balloon is due, combining the first and second mortgages together.
Subordinate financing, whether a HELOC or a fixed rate second may be offered by the same lender providing the first mortgage or by a separate lender specializing in these types of loans. Either way, due to the higher risk position of the second mortgage holder, the interest rate will almost always be higher than that of the first mortgage.