ARMs?

Question

Please excuse my ignorance in this subject... I was just reading a book the other day that talked about buying a property using the loan type of ARMs for 3 years or 5 years, which for what I understand is only paying interest for that time, after that I would either have to refinance or sell the property. Please explain if this really works? I mean buying the house and then renting out, and when the terms are about expire just sell the house or refinance, is this how people make a profit????

Jon Holdman · Answer

I'll explain, but the real answer is you don't need to know any of this if you're just buying SFRs because you want to stay away from all these junk mortgages. An ARM is an adjustable rate mortgage. This is fairly simple. When you get the loan, it has some specific interest rate. Often lower than a 30 year fixed rate loan. The payment is computed at the current rate. After a few years, the rate may be adjusted, most likely upward. The payment is recomputed using the new rate, the current balance and the number of remaining payments. For example, say you get a 4% ARM that will adjust after three years. You borrow $100K for 30 years. Your P&I payment is $477.42. After three years, the rate adjusts, and now its 6%. The loan balance is $94,498.73 and you have 27 years to go. The new payment is now $589.66. Most ARMs have a cap on how much the can change each time and how much they can change in total. But you must be prepared for it to jump every time. Another type of loan is an interest only loan. With an interest only loan, you pay only the interest each month. On a 6%, $100K loan, that would be $500 a month. Because you're only paying the interest, and not any principle, you'll never pay a loan like this off. So, these usually have a balloon payment, and at that time you have to either refinance, sell, or get foreclosed on. An ever worse kind of loan is a negative amortization loan. Also called a pay-option arm, option ARM, and numerous other names. Consider the 6%, $100K interest only payment of $500 a month. An option ARM would allow you to pay only, say $400, a month. What happens to the extra $100? It gets tacked on the loan balance. So, the amount you owe goes up, not down. These loans usually have a limit. Once you hit that limit, say 115% of the loan balance, the loan "recasts" into a fixed rate loan. So, consider the $400 payment. The first month the actual interest due is $500, so $100 gets tacked onto the balance. The second month, the interest due is $500.50. You only pay $450, and $50.50 gets tacked onto the balance. After 112 payments, just over nine years, your balance hits $114,964.63. The next payment would put you over 115% of the original balance, so now the loan recasts. The recast is often at a much higher rate. So, lets say this one recasts to 9% with 248 payments left to go. The new payment is, are you setting down $1022.52. If you want to buy and hold SFRs, get a 30 year fixed rate loan. Rates are very low right now, and it would be foolish to get some tricky loan. If your deal only works with one of these tricky loans, its a crummy deal. Commercial is different because you just can't get 30 year fixed rates loans. But you seem to be talking about SFRs.

Jon Holdman · Answer

Buying a house and renting it out will work if you buy right. Paying $100K for a house that rents for $1000 is a sure way to lose money. Read the sticky threads in the rental property forum about the real expenses. That are many more than you think. Buy with 30 year fixed rate loans. Not interest only. Not ARMs. Certainly not option pay ARMs. A interest only payment on a $100K loan at 5.626% is $469. Don't know how you came up with $448. A 30 year fixed at the same rate would have a payment of $575. A simple rule of thumb is that to break even (not make money, just break even) the rent must be double the P&I payment. So, the minimum rent for this property to break even would be $1150. Read and learn before you actually do any investing. Right here at BiggerPockets is a good place to start.

Drigo Vie · Answer

Thanks a lot Jon, I had it all mixed up, I thought an ARM type of loan was an interest only loan... Heres the thing I just wanted to make a little profit renting the property. I thought it worked a like this, I get a 100k loan interest only 5.626% with a monthly payment of $447.92. Put the house up for rent, hopefully find a renter as fast as possible and rent it out for what rent goes around my area, something like $1000. Subtracting my monthly payment of the loan it would be a nice profit monthly... I do understand theres property taxes and community maintenance fees yearly, so I would have to subtract this monthly from the rent money received. And once the fixed rate it close to finish just sell the house, hopefully for a profit as well... I would love to hear your input on this. Also do you know any great books in real estate? Thanks a lot!