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.

30A Condo Lending

Info for realtors and borrowers on 30A

A common mistake for buyers looking for mortgage financing in South Walton is to perform an internet search for the “lowest rate” when shopping for a mortgage for a single family home or condo purchase.   The loan officer may look at income and assets and make a determination on qualification without having a valid understanding of the local marketplace. A loan officer unknowingly quotes rate and down payment options based on conventional lending terms. Weeks later the borrower gets hit with the news that they are going to have to put much more down, have a much higher interest rate, or both.

When it comes to financing a condominium in South Walton, most properties are considered “non-warrantable” based on Fannie and Freddie guidelines. The concentration of investor owned units is deemed to be a higher risk and thus are labeled “non-warrantable”. These non-warrantable lenders typically charge a premium of 1 to 1.5% in rate and often require 25% or more down.

It’s important for potential buyers to work with local lending sources who have a sound knowledge of the subject properties and access to portfolio lenders. Loan officers will need to clearly explain the potential added financing costs of condo ownership.

Let’s look at a sample scenario on a $1,000,000 condo purchase, with a 25% down payment. Again, most portfolio lenders will charge a premium as much as 1 to 1.5% in rate. So for a non-warrantable condo, we will assume 5% interest rate on a 5/1 ARM

  • Down Payment – $250,000
  • Principal and Interest – $4,026
  • Insurance – $150
  • HOA Dues – $1,416

Total monthly cost is $5,592

Alternatively, consider a $1,250,000 single family home. Many lenders will only require 20% down and currently 5/1 ARM rates are 3.25%.

  • Down Payment – $250,000
  • Principal and Interest – $4,352
  • Insurance – $500
  • HOA Dues – $361

Total monthly cost is $5,213

Of course there are other factors such as taxes and maintenance costs – this is merely a quantitative approach to assist a buyer on the decision tree. This is also not to say single family is a better route. We all know you’re not going to get an ocean view for $1M in single family anywhere along 30A.