Stress Testing ARMs in case of Interest Rate Black Swan event

[Marshall Hooper]

I recently closed a wrap-loan with a local bank where I financed a home with a 3 year ARM on 20 year amortization and then sold the home as owner-finance with a 5 year ARM and 30 year amort. Having to this made me cringe a little, the original strategy on the project was to BRRRR, but due to some hidden costs that popped up, renting it out no longer looked like a solid return. The buyer made it clear she wanted to refinance it in a year once she improved some credit and could acquire an FHA, which I was fine with. But I knew in the back of my mind that if her plans didn't work out, there could end up being some substantial risk for me if interest rates popped. When it was all said and done, between the cash-out refi and her deposit, I had almost all of my money out of the project and had a few monthly cash flow dollars in my pocket due to the interest rate spread. It almost seemed too good to be true.

I know that I'm not the only investor using this program with this bank and I know this is not the only bank out there offering this program. In fact, I often see many newer investors in here talking about their 5 year balloons on their properties. I'm also seeing many many newer investors offering owner-finance at 10-12% interest rates, many times not even qualifying the buyer except for if they have the down-payment or not. These are usually 20 and 30 something year old's and I highly doubt they own the homes free and clear that they are offering as owner-finance. They must be using this wrap loan. 

My question is, how many of you that are using these creative finance techniques have actually put some proper stress-testing on your portfolio? And by stress-testing I mean calculate what your debt service could end up being if by the time your 5 year balloon comes due, interest rates have hit 12-15%?

A stress-test does not mean use reasonable expectations, it's a test that uses extreme events to see how well a portfolio could hold up. 

For these owner-finance properties that are back-to-backed with 5 year ARMs, if the buyer is paying 12% interest, then how easy will it be for them to walk-away in 5 years when you ask them to refinance at 20% because you had to refinance at 15%? It's likely that they will have no equity in the home, especially if we are in the middle of a recession and their original 15 or 20% deposit has been eaten up by market depressions. 

My background is in trading, so I naturally have to think about worst case scenarios and how a "crowded trade" could play out. I'm just curious if anyone else on here has thought about this as well.