As you know, I’m a big proponent of buying real estate right now. And after you’ve secured your property, one of the first things to consider is what type of mortgage you should get. There are all different types of loans and terms you can get, but fixed mortgages, followed by Adjustable Rate Mortgages(ARM), are generally the two most common.
When I bought my first property, I locked in a 30 year fixed mortgage at 5.25%. Since then, I have refinanced to a 7/1 ARM and then refinanced again! My current rate now stands at 3.125% for a 7/1 ARM. With housing prices and interest rates so low, even if I were to move out, I would have a very favorable rent spread. Meanwhile, I’m able to build equity and get a small tax savings from the interest deduction.
Although every situation is unique, I think there are some general principles that apply to everyone depending on what stage they’re at in their life. A fixed mortgage might make sense for some, but an ARM will give you the lowest payments and provide some added perks we’ll see below.
The most traditional mortgage is a 30 year fixed mortgage, where your payment stays the same for the life of the loan. The rate you lock in at will be your rate until you pay off the loan. The shorter term you select(ie 15 years), the more favorable your interest rate will be. You’ll be adding more equity to your house, but your monthly payment will be significantly higher.
This is generally the most conservative or safest approach. It gives you peace of mind knowing that your payment will never go up for the life of the loan. Unfortunately, this is really the only benefit of a fixed mortgage. A lot of first time homebuyers choose this approach when in fact, they should be doing the opposite. This was one of the first mistakes I made in real estate
I think a fixed rate mortgage makes sense for older investors(think 30′s, 40′s) when interest rates are low(like right now!). Right now is a great time to lock in a low fixed interest rate if you know your family size, have a stable career(s), and can see yourself living in the same place for 20+ years. I wouldn’t lock in a 30 year fixed, but a 20 year fixed can definitely make sense for some people in today’s current interest environment. If interest rates were to rise though, I don’t think fixed rates are good for anyone. Why would you ever want to lock a rate when interest rates are high?
Adjustable Rate Mortgage
An ARM is attractive to many buyers because it gives you the lowest interest rate and monthly payments. Even in an already low interest rate environment, why pay more than you have to? The average length of home ownership is seven years, so why not match your rate with your intended stay? If you plan on living in the house for only 5 years before upgrading, get a 5 year ARM.
Many people think that there are no caps on ARM’s, but that couldn’t be more false. On your HUD-1 closing statement, there will be very clear documentation that explicitly lays out the maximum rate your loan can ever adjust to. Typically, the adjustment amount is 5%. So if your loan is at 3%, you will never pay higher than 8%. Generally, interest rates are a reflection of inflation and if the economy is booming, interest rates are rising, I know the value of my property will also be appreciating. If my property goes up by 5%, and I have a LTV of 80%, I’m getting a 25% cash on cash return!
One of my favorite benefits of an ARM is the ability to refinance. I love to refinance, and I don’t want to pay one cent to do it. In fact, with my latest refinance(Amerisave review is coming next week), I actually made $300 that was credited to my escrow prepayments. ARM’s allow you to no cost refinance as often as you’d like. As long as you have good credit(740+), and a LTV of 80% or lower, you don’t need to worry about rates dropping. Two years ago, how many people do you think predicted that interest rates would continue to decline? Nobody!
So What Makes Sense for Who?
In today’s low interest environment, fixed rates can make a lot of sense for older investors who want to lock in a low rate. If you’re able to lock in a low rate, rent out your property for 10% cash on cash, who cares if interest rates go down another percent or two? A lot of retirees who have a fixed income stream would benefit from a fixed mortgage because they know exactly what their monthly payment will be and for how long.
I don’t recommend, nor do I believe that most people’s first real estate purchase will be their life long home. Generally, young couples buy a small condo or small house and as their family size increases, they upgrade to a more permanent place. Since purchasing my first condo, I’ve learned a lot about what I like/dislike in a property that will help me when I buy my next home.
As always, with increased risk, their is increased return. ARM’s provide some benefits that conventional fixed loans couldn’t dream of and as a young investor, I’m happy to take on this risk. I know that I’ll save money every month for the next seven years and I’ll be able to no cost refinance whenever rates drop. As we’ve seen, there’s no guarantee that rates will go up
What do you think about an ARM vs. Fixed Mortgage? Would you rather have the security of a low fixed rate or do you like the idea of a lower monthly payment?
-Harry @ PF Pro