ARM vs FRM

Private Lending & Conventional Mortgage Advice

ARM vs FRM

Chicago, IL · Member since 2009 · 2 posts · 0 votes

Can someone please describe to me the thought process they go through when deciding on whether to finance a property through fixed or adjustable rate mortgages? More specifically, I'm talking about residential single-family investments. Now my understanding is that ARMs typically offer lower rates to the borrower because much of the interest rate risk is transferred from the lender to the borrower. This spread between the ARM and FRM rate also will depend on variables such as the index, the margin, adjustment frequency, and any interest rate or payment caps. It seems to me like if I'm going to have a short holding period (1-3 years) that I would want to take advantage of the ARM, especially if there is a good teaser rate, because the interest rate risk will not be high enough for this short time to justify me paying more for the FRM and a stable payment. Now, I don't have any investing experience (yet) but I'm looking to start soon after graduating so I was hoping for any real-life insights on this topic. Especially now where rates are so low and the fed looks to stop its program of buying mortgage backed securities in March, the fear of rising interest rates has hit us all. I was wondering how this might also affect the decision of ARM vs FRM. Thanks!

103 views

Most Popular Reply

Banker · Fort Lauderdale, FL · Member since 2010 · 22 posts · 13 votes

Hi Eric...
One thing I know from doing real estate financing for a longtime is that no one product fits everyone. Their is no "perfect mortgage" if their was we would only have one product.

Everyone's situation, goals, issues etc are different.

In this market a very tight margin exists between fixed and arm's. So, in general most folks these days have opted for the fixed rates - especially in this fear driven market.

A few reasons a person may choose an adjustable over a fixed rate:

1) They are tight on ratio's and the only way to qualify is to get that extra little bit of a lower rate.

2) I have a lender who will finance and allow a closing under a Corporation Name (Fannie, Freddie, FHA - Most banks portfolios wont allow this) - they dont offer fixed rates.

3) The amount of the loan. Surely on a 30k mortgage the difference in rate makes such a minimal effect on payment - but for those with large loan amounts they can surely save an awful lot of money by having a lower rate even if it is only slightly lower - not to mention that the loan amount ammoritizes much faster - the client saves a ton on the monthly payment - with good caps - the borrower has very little risk and has the initial on going savings and faster ammorization to bank on. Then yes, it makes sense. I have done the numbers on some clients and yes it pays for them to do a ARM - again these are large loan amounts.

Do a Ben Franklin - put the plus's and minus's on paper look at the numbers and find out what is right by you.

Other thought look into buying down the fixed rate - if the property will appraise maybe you can negotiate seller concessions and use those funds to buy down whatever mortgage you choose.

Carter

See this reply in the discussion

18 Replies

Jump to latestLatest

Sort by

Praveen Kumar
Specialist · Auckland, Auckland · Member since 2010 · 16 posts · 1 vote
16y
Interest rates will start rising as soon as the economy stabilizes. Fix your rate at the first sign of increase in ARM.

Go for a transferable mortgage in case you wish to sell the property in couple of years time.

Praveen
0 Reply
Bryan Hancock
Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
15y
I saw this old thread today when searching for something else. In case anyone has the same question there is a tutorial here:

Mortgage Professor Tutorial

I think people would be foolish to use ARMs for anything they can get fixed right now.
0 Reply
Kevin C.
Investor · McKinney, TX · Member since 2009 · 405 posts · 160 votes
15y
Why on earth would you even consider an ARM when fixed rates are where they are today???

Regardless of intent, things happen that throw a wrench into plans. That ARM turns into a rope around your neck when things don't go exactly as planned.

There are variables in your life that you do not control, those variables outside your control are the ones that WILL jump up and bite you.

I wouldn't touch an ARM, EVER!
0 Reply
Bryan Hancock
Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
15y
The right ARMs are better product in certain circumstances IMO. Financing one property in your portfolio on an ARM and prepaying it to pop cash flow is a good idea. This is better than duration decreases with FRMs.

I also think some ARMs with low ceilings, non-volatile fully-indexed rates, etc. are better product than 20-year FRM debt with high constants. This is especially true when you exceed the Fannie/Freddie limit on loans and can't buy sub-to for the deal in question.
0 Reply
Bill Gulley
Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
15y
Very good comment Bryan!

As an investor, the fixed may be a fantasy.

Jumbo loans can be piggy-backed with ARMs.

Another product is the 5 or 7 year ARM, fixed for 5 or 7 years (or other mid-terms) and rolls over to an adjustable rate.

First question is what is the use of the property? Second is what is the expected term to hold the property?

This becomes a "use of funds" analysis, but to make it advantageous you need more income than the required payment. Making additioanl payments to principal will be required to lower the principal amount bearing interest. Tax considerations also come into play. I have always suggested taking the longest amortization possible, so long as there is no pre-payment penalty, since you can schedule payments to payoff debt at any time. This lowers your obligation and ratios when applying for other financing and in the event of a cash crunch, you're only obligated to pay the lower amount.

There is a time and circumstances where an ARM is the better option. Many ARMs have a conversion provision, giving the borrower the right to convert to a fixed rate in the future at the then going rate. Kind of a spin off from the guaranteed insurability in a life insurance policy.

I won't put this to numbers here, you can do that, but if you take a 30 Yr. ARM and make additional payments to amortize the loan to 15 years at the rate of a 15 Yr. fixed, you're looking at about 12 years. Converting in the 7th year when it will adjust, depending on rates then, (amortized for the remaining 23 years) and continuing to pay the original payment amount will put you on target for an early payoff. This is assuming rates stay within about 2%, and you can usually buy down interest (which is pre-paid interest and tax deductable).

I have used this strategy, as well as investing the difference in the payments for three cycles, over 15 to 20 years and has worked effectively to lower interest expenses.

Your business plan or personal goals are important to assess, those first two questions are key. And, to play this game it requires ongoing effort to stay on top of your debt, watching rates and keeping yourself in good financial health.....but can be well worth the effort especially since you are in the real estate arena watching the market anyway! Good luck....
1 Reply
Account Closed
Banker · Fort Lauderdale, FL · Member since 2010 · 22 posts · 13 votes
15y
Hi Eric...
One thing I know from doing real estate financing for a longtime is that no one product fits everyone. Their is no "perfect mortgage" if their was we would only have one product.

Everyone's situation, goals, issues etc are different.

In this market a very tight margin exists between fixed and arm's. So, in general most folks these days have opted for the fixed rates - especially in this fear driven market.

A few reasons a person may choose an adjustable over a fixed rate:

1) They are tight on ratio's and the only way to qualify is to get that extra little bit of a lower rate.

2) I have a lender who will finance and allow a closing under a Corporation Name (Fannie, Freddie, FHA - Most banks portfolios wont allow this) - they dont offer fixed rates.

3) The amount of the loan. Surely on a 30k mortgage the difference in rate makes such a minimal effect on payment - but for those with large loan amounts they can surely save an awful lot of money by having a lower rate even if it is only slightly lower - not to mention that the loan amount ammoritizes much faster - the client saves a ton on the monthly payment - with good caps - the borrower has very little risk and has the initial on going savings and faster ammorization to bank on. Then yes, it makes sense. I have done the numbers on some clients and yes it pays for them to do a ARM - again these are large loan amounts.

Do a Ben Franklin - put the plus's and minus's on paper look at the numbers and find out what is right by you.

Other thought look into buying down the fixed rate - if the property will appraise maybe you can negotiate seller concessions and use those funds to buy down whatever mortgage you choose.

Carter
2 Reply
Account Closed
Landlord · Seattle, WA · Member since 2010 · 3k+ posts · 1k+ votes
15y
There are circumstances that an ARM or even an interest only loan might work. You always want to look at the other terms as well. Sometimes a prepayment penalty applies and this can drastically change the advisability of a loan product.

You can sometimes negotiate the terms of a note especially if it is a commercial loan.
0 Reply
Kevin C.
Investor · McKinney, TX · Member since 2009 · 405 posts · 160 votes
15y
Originally posted by Carter Jasicob:
Hi Eric...
A few reasons a person may choose an adjustable over a fixed rate:

1) They are tight on ratio's and the only way to qualify is to get that extra little bit of a lower rate.

Carter

If someone's finances are so tight that an ARM is the only way they'll qualify, they're stretched far too thin.

0 Reply
Bryan Hancock
Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
15y
There are other advantages to an ARM in some circumstances too Kevin. They aren't only for people stretched too thin.
1 Reply
Account Closed
Banker · Fort Lauderdale, FL · Member since 2010 · 22 posts · 13 votes
15y
Kevin

That is a personal issue and belongs to the person who is qualifying.

You assume a lot with knowing little.

So, since you are the financing police and everyone has to get approval with your blessing...

Hmmmm...

So, if the husband is not on loan because of credit and he makes big $$ - would that be relevant?

If the person is just out of medical school and is expecting a big time contract, would that be relevant?

If a person just inherited the big bucks but dividend income could not be used....yet...would that be relevant?

If a spouse just went to a 1099 income and we could only use one income...what ya gotta say now?

I could go on and on...and on and on...I could give you plenty of scenarios...

Pretty narrow thinking Kevin...

Unfortunatley you don't know everything about your neighbor...maybe you can just support them by being a kind neighbor not some narrow thinking financial police who knows nothing.

You dont know what you dont know Kevin.

That was not a very smart comment. Shows your lack of knowledge, empathy and plain common sense.

But next time I need a loan I will contact you for your non knowing ethical compass...seeming you dont know my nor anyone else's life, family, situation, financial picture, assets, income situation etc etc...

0 Reply
Steve Babiak
Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes
15y
Carter, I would agree with most of your post ... until it became a bit condescending. You can accomplish getting the message across by listing all of your examples - because they certainly are legitimate instances (among many possibile others too) - and by staying nice :D .
2 Reply
Account Closed
Banker · Fort Lauderdale, FL · Member since 2010 · 22 posts · 13 votes
15y
Steve

I agree with you. My apologies for being too rough. Not an excuse but rough day - either that or after being in south fl real estate for the past years I'm like a punch drunk fighter who starts swinging when he hears a bell.
2 Reply
Account Closed
Landlord · Seattle, WA · Member since 2010 · 3k+ posts · 1k+ votes
15y
For anyone looking for a stated income product available in some other states.

http://www.loanshoppers.net/stated.htm

(limited to CA, WA, NJ, NY, NJ, CT, MA, PA, DE, NH, RI, TX, GA and FL (Florida is 50%).

Stated income, 60% to $1,000,000
55% to $3,000,000

Applies to home, second home and residential investment properties.
0 Reply
Kevin C.
Investor · McKinney, TX · Member since 2009 · 405 posts · 160 votes
15y
My skin's thick enough to take it - no offense taken.

You've made a number of valid points, the problem is, my guess is the majority of ARM's taken out in the past were by those that shouldn't have been getting loans in the fist place.

Part of the reason we're in the mess we're in today is due to bad loans, many of which were ARM's.

There may be times when an ARM may be worth looking in to, but even then, there is additional risk with an ARM.

A savvy individual may be able to handle an ARM just fine, problem is, so many of the people that get into an ARM are not very financially literate.

I'd venture to guess that a good chunk of the population can't even balance a checkbook, much less understand the ramifications of an ARM.

This is a public forum and I has as much right to state my opinion as the next guy.

I stand by what I said - with rates where they are today, an ARM has little relevance.

That's my opinion, and it's worth what you paid for it - nothing.

Have a great day.

Edit to add:
Regardless of the scenario, including all that you mentioned, unexpected things happen that can lock you into where you are - and if where you are happens to be an ARM, it can bite you.
0 Reply
Kevin C.
Investor · McKinney, TX · Member since 2009 · 405 posts · 160 votes
15y
Originally posted by Bryan Hancock:
There are other advantages to an ARM in some circumstances too Kevin. They aren't only for people stretched too thin.

I agree there may be advantages to an ARM, but it cuts both ways. That advantage comes at a price, the price is added risk.
0 Reply
Bryan Hancock
Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
15y
An ARM does expose you to interest rate risk, but the tradeoff is increased cash flow with prepayment and lower rates in the short run. Different tools are good for different jobs.

Interest rate risk has to be mapped to someone so you pay a premium on a FRM for transferring this risk to the lender in the absence of government guarantees.
0 Reply
David Beard
Investor · Cincinnati, OH · Member since 2010 · 1k+ posts · 928 votes
15y
Maybe a separate thread would be helpful on hedging the interest rate risk of an ARM (i.e. converting the ARM to a FRM using financial instruments), in cases where you're stuck using an ARM because you're funding with a local bank, or one of the other reasons cited.

Options that come to mind for a retail investor:
1) Short intereste rate futures
2) Short a short-duration (1-2 year) bond ETF

Problems: hedges don't line up perfectly, might need cash on hand if rates actually move down, cash flow mismatch, etc.

Anyone had luck with these approaches.
0 Reply
Bryan Hancock
Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
15y
I wrote about a hedge in a separate thread. Futures contracts coupled with lines of credit are the way to go.

I would love to explore this some in a separate thread if you would like to create one.
0 Reply

Join the conversationCreate a free account to reply, vote on answers and follow this thread.

Log In Join for Free