Mastering Leverage: Should I get an ARM or a 30-Year Fixed Mortgage?

Irrespective of strategy, securing cheap and affordable debt is probably the most crucial aspect of your real estate investment. Of course, location is important, rental rates and purchase price are also important, but leveraging incorrectly will make or break any investment.

As an amateur investor, one of my earliest mistakes was not understanding the difference between leverage options. My mindset was to always hedge interest rate risk and obtain fixed long-term financing, and this was even more attractive due to historically low fixed interest rates. However, as I began to crunch the numbers and understand the implications of my 30-Year fixed 4.00% APR mortgage on my rental, I realized that my 30Y fixed rate leverage was a terrible strategy.

Despite getting 4.00% APR on an investment property - which is a feat in itself - I could’ve gotten a 7/1 ARM or a 5/1 ARM that will only be about 2.00-2.50% APR. This will bring down my mortgage at around $100-$200 on a monthly basis, meaning I can make an extra $1,200-$2,400/year!

For those who don’t know what an ARM is, you effectively fix your APR at a really low “teaser” rate that is always lower than a fixed-mortgage rate. After 5 or 7 years, the interest rate would float depending on a pre-agreed margin and underlying benchmark rate (1Y WSJ Libor, 10-year US Treasuries, etc.). The term “adjustable” means that your interest rate would adjust to a new rate after your fixed period or “teaser period” is over; and every year thereafter it would be readjusted annually. The product has a designated cap and floor that is also pre-agreed with the bank, so don’t expect to be paying 0% or 20% APR, but there is a possibility to pay lower than your teaser rate when it adjusts.

Most people don’t realize this, but the amortization schedule for an ARM and a 30Y fixed is roughly the same; meaning you still amortize over a 30 year schedule. If that is the case, and your investment horizon is short, why bother paying more than you need to? At the end of your teaser period, you can: (1) stick with adjusting if the benchmark rate is low, or (2) refi- and get a new ARM (will still beat the 30Y rate at that point).

What about interest rate risk?

My investment horizon is always between 5 and 7 years. My strategy is to exit earlier and free myself from all major expenses a house may need (i.e. roof or floors, etc.), so an ARM option is the perfect leverage option.

Given the 5 and 7 year investment horizon, one could see the advantages of incredibly low cost of funds and more cash in the pocket!

What crazy person would want to just pay interest?

If it was up to me, I would even do an IO which means interest-only.

Getting a 5 or 7 year IO - if you even qualify for one - is actually similar to the ARM strategy above. In fact, an IO will probably get you an even better rate than a normal ARM, meaning even lower cost of funds, so your Net Operating Income (“NOI”) will be even higher! IO works in a similar way as an ARM but doesn’t amortize down your principal amount. There might be prepayment penalties, so you may not freely pay down the debt as you’d like. One problem with an IO is that the loan-to-value (“LTV”) on the home doesn’t go down because you don’t make principal payments, so if the market is not doing well, you may be in a bit of trouble if the home goes underwater. This is an extreme scenario though, given that lenders probably won’t lend above 80% LTV.

IOs also have a problem since you effectively don’t accumulate equity on your home. For investors who don’t care about that, and simply want to maximize the most amount of in-pocket revenue, this would definitely be an attractive option.

For anyone considering a fixed-rate mortgage on their investments, consider an ARM option, it might be the best strategy for you in the long run! Crunch the numbers, and see what works for you. Good luck guys!