Building Equity: Adjustable Rate Mortgages (ARMs)

In a low interest rate environment, many investors are inclined to consider a fixed rate mortgage.  In fact, according to the National Associate of Realtors, approximately 95% of people chose fixed rate loan in 2014.  Some homeowners may consider an Adjustable Rate Mortgage (ARM) may have its advantages.  An ARM, however, should not be used as a means to afford a larger home.  It can be a strategic tool to lower cost of capital, and perhaps build more equity in your property.

As a disclaimer, an adjustable rate mortgage should only be considered by experienced homebuyers who have a strong financial grasp of the complexities of an ARM.  Real estate investors that might consider an ARM might already have multiple properties and many times sufficient outside liquidity.  For more information on ARMs and how they work, you can look here.

In this example, we are examining the costs/benefits of $1,000,000 loan amount.  For the 30 year fixed rate we are assuming 4.0%.  For the ARM, we are assuming a 5/1 ARM that is currently 2.99%.  On a $1,000,000 loan:

  • 30 Year Fixed PMT = 4,774
  • 5/1 ARM PMT = $4,221

Equity

At the end of  year 5 it’s interesting to note that even with the lower payment, the 5/1 ARM has a lower principal balance.  The principal balance of the ARM is $888,901 vs. $904,475, or about $15,000 in additional equity.  Consider an additional payment to the 5/1 ARM as if you had financed a 30 year fixed ($563 per month) and you now have a principal balance of $852,514 vs 904,475, or about $52,000 in addition equity.  This can also be helpful in reducing payment shock below.

Payment Shock

As of Aug 13, 2015, the current 1 year LIBOR is .84.  Most ARM rates adjust by a margin of 2.25%.  For the purpose of the exercise, it is  assumed that ARM rate increases 2.00 bps over current the next 5 years and an additional .25 bps each year beyond that.

Year (ARM) 30 Year Fixed 5/1 ARM 5/1 (30 Year PMT)
6 (4.99%) $4,774 $5,191 $4,979
7 (5.24%) $4,774 $5,317 $5,100
8 (5.49%) $4,774 $5,441 $5,218
9 (5.74%) $4,774 $5,562 $5,334

Finally, if you are certain that you will be holding the property longer than 10 years, there’s not much advantage to an ARM.   Why use short term financing on a long term asset?  Also, there’s nothing wrong with having the piece of mind of a low rate locked in for 30 years.

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