9yr Arm, 5yr Balloon???

[Rick L.]

I have made a connection with a commercial lender at local community bank. After speaking with the commercial lender, they're willing to offer the following loan vehicles with as little as 15% down payment. I have little understanding of ARM and especially balloon loans. However, some information I've read states they both can be rather risky. I'm a small buy and hold investor who is interested in acquiring cash-flowing properties to quickly build my portfolio. I would like the properties I acquire to be self-sustaining and don't want to get myself into trouble financially. I have always prided myself on my financial responsibility and >800+ credit score. I would prefer a fixed rate type loan, however I suppose these loan vehicles are more commonly use in the commercial sector? Here is an excerpt from her email explaining each loan:

"As mentioned on the phone, we have a 9 year ARM that we can offer. This works with a normal amortization (typically 25 years or less).

First Three years: 3.25% (unless we have a amortization of 10 years or less, in which I can offer 2.99%)

3-6 years: The three year treasury plus a spread of 2.50% with a cap of 5.25%

6-9 years: The three year treasury plus a spread of 2.50% with a cap of 7%

***Currently the 3 year treasury is .93, so with a spread of 2.50%, you would have a rate of 3.43%***

To make this visual, based off $100,000, on a 20 year amortization, below would be your worst case scenario for 9 years.

0-3 years: $567.20

3-6 years: $659.02

6-9 years: $732.31

I can also offer a 5 year balloon. Rates are normally in the low 4’s. Based on $100,000, on a 20 year amortization, with a rate of 4.25% you would have a payment for five years of $619.23.

Once the balloon or ARM is up, we would renegotiate the terms. Those terms are based off the current market. We do our best to stay competitive so you have no reason to want to leave TheBANK.

What concerns should I have with these type of loans?  What are some pro's and con's of employing these particular loans?  Is it even worth the effort, as a buy & hold investor, to use a 5 year or 9 year loan and then have to renegotiate terms to whatever is available at that time?  It all just doesn't seem to pass the smell test to me, but what do I know... Any comments would be greatly appreciated.

[Dion DePaoli]

@Rick L. 

On the ARM loan, to rephrase the terms:

Index:  3 Year Treasury (Historical Trend HERE 3YR T Bill )
Margin:  2.50%
Adjustment Cap:  2.0% (+/-)

So in an Adjustable Rate Mortgage - the Index plus the Margin equals the rate of interest. So today the ARM is 0.93% (3yrT) plus 2.50% (Bank Margin) = 3.43%

The bank margin is a constant number, static at 2.5%.  The index is a market number, meant to float with the economic market.  It is outside of the control of the bank.  

If you would have received this same loan terms in 2007, your rate would have been dropping since the index has dropped (look at the graph link) since June 2007.  The manner in which the index is applied is usually a rolling average, not a day of, sort of thing.  

It looks like per the conversation, which nice job with the dictated notes!, the loan officer was quoting generically, perhaps from a slightly dated rate sheet and then brought the loan to market.  When he began talking about the ARM, he mentioned 3.25%, so based on above in reverse 3.25% minus the margin of 2.5% would leave us the index rate used or 0.75%.  If you reference the chart, (might need to make it go to a 1 year span), we can see the last time the index was at 0.7% +/-  was March 2014.  That's not a conspiracy for anything, it could also just be him using easier numbers for the math for you and he to discuss and you to understand what he is offering.  

The adjustment cap he mentions by quoting the highest 'possible' rate.  So in year 1 to 3, you are at 3.25% (which is really 3.43%) and in year 4 the loan can adjust to 5.25% or 2.0% higher but that only happens IF the index goes up 2.0%.  If the index goes up less than 2.0%, then you take that number and apply to to the margin to come up with the rate.  The adjustment cap prevents the loan rate from exceeding the Index plus the Adjustment Cap plus the Margin or in the first reset period 5.25%.  

I would guess he did the same thing in the second adjustment but just got verbally lazy and said 7.0% instead of 7.25%.  Perhaps knowing that the 0.25% is not really proper anyway.  At the time it was 0.43%.  Most of the time ARMS have a universally applied set of caps, they do not typically carve out one adjustment time period.  It is possible as well, that the loan carries a lifetime cap of 7.0%, which means the loan goes not higher than that ever, regardless of market movement.  

So, that is a basic run down of how the loan will work.  So, when modeling, you can use the time periods and caps to create worst case scenario for yourself.  That is, since the cap creates a rate ceiling then the rate in that time period can go no higher, it can only be lower.  There is usually a floor, but we need not worry about that right now.     If you wanted to create a model that has some logic, plan rate increases to rent at the same time the adjustment period happens.  Fundamentally, that is sort of what real life would look like. 

So, for every 0.25% in index movement which affects your rate, factor a 10% rate increase or something of that nature.  I made those numbers up.  I would have to play with the numbers a little to figure out what i wanted to use.  For a conservative model, simply use the current rental rate unadjusted through term and see how it affects your margin.

When you start modeling out that far, past 3 and 5 years more guessing and less knowing comes into play.  That said, it will give you an idea of a an action plan to work with.  A little more so than using a static average to work with rental rate increases.  Both will fundamentally get you to a similar place though.