ARM

Mortgage Evaluations

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Rate Sheet Options from your Lender

When reaching out to a loan officer, there are a lot of options to choose from. I’m hoping to break down the decision-making here. I’ll share how we ended up with several different options, too.

Basically, it boils down to: 

  • Put enough down to avoid paying Private Mortgage Insurance (PMI)
  • Don’t pay more than 20% unless there’s a decent incentive. 
  • Don’t pick a loan term shorter than 30 years unless there’s a decent incentive. 
  • Carefully evaluate any Adjustable Rate Mortgages (ARMs).

PMI

I broke down PMI in a previous post: PMI – Private Mortgage Insurance. We suggest doing whatever you can to meet the requirements to avoid paying this. The cost of PMI can be a couple hundred dollars per month, which is money that can be put towards the principal balance of your loan or other bills, rather than in the bank’s pockets. There are also hoops to jump through to remove PMI early, which may include paying for another appraisal on the house ($400-$700!).

LOAN TERMS

A conventional loan will likely require 20% to avoid paying PMI. There are some loan options out there that may allow a smaller down payment without a ‘penalty’ (e.g., PMI, higher interest rate), but 20% is the standard, and is usually required when purchasing an investment property.

There may be an option to put down more than 20% or you may think you can afford to pay a higher mortgage each month, so you’re interested in a shorter loan term. Unless there’s an incentive (e.g., lower interest rate, better closing costs), stick with the bare minimum to get the loan.

If there is an incentive, you’ll need analyze the math and your goals to determine if committing extra money to a higher down payment or a larger monthly payment is worth it. If you have extra cash each month, you can pay more towards your principal rather than pigeon holing yourself into a higher monthly payment. Plus, if you have more cash liquid, you may be able to purchase another rental property, which will increase your monthly cash flow.

While we evaluate the loan terms on every house purchase, I’ll share the details of the two most “unconventional” options we chose. Two things to note: 1) lenders add a ‘surcharge’ to the rate for it being an investment property, typically around 0.75%, which means the rates aren’t going to be the great, super-low, rates being advertised; and 2) the term “point” means a fee of 1% of the loan amount.

HOUSE #2

For House #2 (purchased in 2016), we were informed that if we put 20% down instead of 25%, the rate would increase 0.25% on average. If we assume a 30 year conventional loan, 20% down at 4.125% equates to about $69,700 paid in interest (assuming no additional principal payments); 25% down at 3.875% equates to about $60,800 paid in interest. By putting an additional $5,850 as part of our down payment, we saved about $9,000 in interest over the life of the loan.

Once we determined that we’ll put 25% down, we then had to figure out the appropriate loan length. On this particular offer, 30 year amortization wasn’t an option for us because we would have had to pay a point to get a competitive rate. We chose a 20 year amortization because the house already came with a well qualified tenant, we didn’t expect a lot of maintenance and repair costs due to the house’s age, and we didn’t have an immediate need for a higher monthly cash flow based on our place in life at the time.

While our long term goal was to have rental property cash flow replace our W2 income, this house was early in our purchasing. At the time, we were focused more on paying off House #1 (higher rate and a balloon payment after 5 years). Frankly, we didn’t truly understand the power of real estate investing at this time, and didn’t know how much it would accelerate the timeline for us to meet our goals. By decreasing our loan length, we increased our monthly payment, but also lowered the total interest paid over the loan’s life by over $22k. Since more of our monthly payment is going towards principal reduction than had it been a 30 year amortization, this loan isn’t on our priority list to pay off early.

HOUSE #3

For House #3, we evaluated the rate sheet for the loan term, interest rate, and down payment percentage again. This house was purchased a few months after House #2, so those rate decisions were fresh on our minds. We were quoted several options: 1) 20% down at 4.25% for 20 or 30 years, 2) 25% down at 3.75% for 20 or 30 years, or 3) 25% down at 3.25% with 0.5% points for 15 years.

As you can see, there’s no incentive to pick the 20-year term because it’s the same rate as a 30-year term. If we have additional cash, we can make a principal-only payments against the 30-year term rather than unnecessarily tying up our money.

At first, we thought paying points was an absolute ‘no.’ However, points aren’t a bad thing. Paying down your rate up front can save you an appreciable amount in interest. Plus, points are tax deductible.

Now for the breakdown of each options. Let’s say the house purchase was $110,000 (because it wasn’t an exact number, and it’ll just be easier to use a ‘clean’ number like this). Microsoft Excel has an amortization template where you can plug in the loan terms and see the entire amortization schedule. 

Option 1: 20% down payment equates to a loan amount of $88,000; the annual interest rate is 4.25%; the loan is for 30 years, with 12 payments per year. If we make no additional payments, this totals about $67,800 worth of interest paid over the life of the loan.

Option 2: 25% down payment equates to a loan amount of $82,500 at 3.75%. If we make no additional payments, this totals $55k worth of interest paid over the life of the loan. This requires an additional $5,500 brought to the closing table, but saves almost $13k in interest. It also decreases our monthly principal and interest payment (i.e., not including escrow) from Option 1 by $50.

Option 3: 25% down payment, 3.25% interest, and 15 years (instead of 30 years) equates to just under $22k paid in interest. To obtain the 3.25% rate, it required “half a point.” If a point is 1% of the loan amount, that would be 1% of $82,500. This rate only required 0.5%, so that meant paying $412.50 as part of closing costs along with the additional $5,500 of down payment required for 25%. However, the shorter loan length means that monthly payment is increased (between Option 2 and Option 3, the difference is $197.63).

For about $6k, we pay a higher monthly payment, but we also save a significant amount of interest over the life of the loan. The short loan term of 15 years means this one is also not on our radar to pay off while we focus on paying down other, higher interest and higher balanced, mortgages. In this case, the benefits of the big picture math outweighed the increase in monthly payment.

We are five years in on this mortgage and are already seeing significant reduction in the outstanding principal due to the amortization schedule becoming favorable more quickly. In 10 short years more, our house will be fully paid for, through rent collection, without a single dollar of extra principal payments from our other financials. What a great feeling.

ADJUSTABLE RATE MORTGAGES (ARMs)

An adjustable rate mortgage can be beneficial depending on the terms and how long you expect to own the house. For us, we expect to hold our investment properties for a long time, so it wasn’t worth the risk of an ARM. Many times lenders won’t even offer an ARM on an investment. However, when we purchased our DC suburb home, we knew we didn’t expect to be there for more than 5 years, so we chose a 5 year ARM.

After a positive experience with that decision, we also chose an ARM on our second primary residence. We chose a 5 year ARM, even though we expected to be there longer than 5 years. We figured we would either accept the new rate, if there was one, at the end of the 5th year, or we would refinance when necessary. As a result, Mr. ODA monitored rates and refinance options over the last year or so. Unexpectedly, we sold that house 3.5 months shy of the end of the initial ARM term so we didn’t have to do anything.

I break down all the details of an ARM and our decision making in a recent post.

SUMMARY

When I reach out to my lender to ask what the rates of the day are and begin the process of locking a rate on a new loan, I ask for options. These options are in the form of a “rate sheet.” When you ‘lock’ a rate, you’re actually locking the ‘rate sheet,’ not the individual decisions of loan length and percent down. For every house, we evaluate the rate savings that can come from doing something less “conventional” than a 30-year fixed at 20% down mortgage. Our decision is based on what’s best for our goals and our cash in-hand.

As shown above, in our early decisions, we favored shorter loan terms for rate savings. but since House #3’s purchase, we noticed how much more we cared about low monthly payments and low down payments to allow us to buy more properties along the way. Every investment property loan since House #3 has been the ‘standard’ 30-year fixed at 20% down. Because of this perspective shift, we were able to buy six properties in 2017, which gives us about $2,000 in monthly cash flow that we can then use to pay down mortgages.

ARM – Adjustable Rate Mortgages

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An ARM is when the interest rate applied to the loan balance varies throughout the loan. The loan is typically amortized over 30 years like a conventional loan would be, but the interest rate is variable. There is an initial fixed interest rate for a pre-determined period of time (e.g., 5, 7, 10 years). The rate then adjusts based on prime rates, with a maximum amount allowed for the increase each period of time (e.g., a maximum 1% increase each year for 5 years). This is where people find ARMs alarming, but note these two important points: 1) an ARM can’t jump an egregious amount at the end of the initial fixed term (usually no more than 1% or 2% in one year, outlined by the lender at the beginning), and 2) the rate is based on interest rates at that point in time.

Usually, the benefit of an ARM is a much lower interest rate during the initial term. If you know that your ownership in the property will only be for 5, 7, 10, etc. years, then this is where the benefit is realized. Amortization schedules ‘front-load’ the interest** (e.g., your monthly payment is the same total ($500); your payment in year 1 will be broken out as $375 interest and $125 principal; year 20 will be broken out at $150 interest and $350 principal).

**Every dollar of your loan is being borrowed for a length of time determined by the outstanding principal on the loan. At the beginning of your loan, all 30 years are being borrowed, so the proportion of principal to interest of each monthly payment results in far more interest being paid. Every month you pay a little bit of principal, gradually decreasing your outstanding principal amount, meaning you are no longer borrowing it and will pay slightly less interest with each monthly payment.**

Therefore, if your interest rate for the initial term is less with an ARM than it would be with a fixed rate loan, you’re saving considerable interest for the time that you own the property. You’ll need to compare the interest rate savings during the discounted initial term of an ARM with the 30-yr fixed quote your lenders offers. Also evaluate an ARM based on how long you anticipate owning the house. If you’re looking to hold a property for more than 7 or 10 years, an ARM’s benefit is probably too risky since interest rates after that timeframe are unknown. Also, the more years your ARM offers for an initial fixed period, the less the discounted interest rate is.

In our current very low interest rate environment of 2020/2021, ARMs are rarely beneficial compared to a 30 year fixed rate.

An ARM is identified by 2 numbers. A 5/1 ARM means that the initial rate period is 5 years, and it can change every year thereafter for the life of the loan. A 5/5 ARM means that the initial rate period is also 5 years, but it can only change the interest rate every year for the 5 years after the initial term expiration. Here’s an example of a 5/1 ARM quote. It shows that the initial period is 60 months (5 years) and the maximum the rate could ever be is 5% more than the initial term, but that doesn’t mean there’s a guarantee of an increase since the interest rate is still based on the rate sheet at that time.

We found ARMs to be beneficial for our primary residences. We had several people try to talk us out of locking in an ARM. However, once we investigated the loan terms, we learned that there are strict parameters around your rate changes that absolved some of the risk others were using to dissuade us from the option. Yes, it’s a gamble, but interest rates have remained fairly steady or decreased over the last 10 years of our home ownership.

When we moved just outside of DC, the move was solely to get back to living together because our jobs had separated us. Being in the Federal government, the easiest way for both of us to get a job was the DC area, but we didn’t want to live in that metro area with the higher cost of living and a lot of traffic for very long. The rate terms offered were 4% on a 30 year fixed, or 2.5% on a 5 ARM. We owned the house for 3 years and 2 months. Over 38 months, we paid just over $23k in interest. Had it been the 4% on a 30 year fixed, it would have been over $37k in interest, which is a $14k savings. By paying less interest, that means that more of each monthly payment went towards principal than it would have, resulting in $4,700 more to principal. Additionally, by having a lower interest rate, our monthly payment was $250 less. Over 38 months that’s $9,500 less we had to pay, freeing it up to save and invest in other ventures.

For our second primary residence, we also had an ARM. We expected our time outside of Richmond, VA to be longer than the DC area, but not forever. I was uncomfortable with a 5/1 ARM and wanted the 7/1 ARM, but Mr. ODA picked the 5/1. We owned this house for 4 years and 9 months. Our interest rate was 2.875%. At the 61st month, it could have risen by 2% for the first year and 1% for each of the next 4 years. Had we gone with a conventional 30 year loan, the interest rate was going to be 4.125%; we would have paid $54k in interest during our ownership. With the ARM, we saved $17k in interest, put $5,300 more towards principal, and paid over $11k fewer in monthly payments.

We purchased our current residence a few months ago. We have a 30 year fixed conventional mortgage at 2.625%. Since interest rates are so low now (you can see how previously, we’d be around 4% for a conventional and got lower than 3% by choosing an ARM, whereas now interest rates are less than 3%) and we plan on being here for a much longer time, we didn’t pick an ARM.

As illustrated in the examples for the first two properties we lived in, ARMs can be a powerful option in strategizing your mortgage to work most efficiently for you. They are not without risk, so pros and cons must be weighed along with future forecasting of your life situation. If used in the best circumstances, they can help you shift tens of thousand of dollars away from interest and towards principal and other investments to aid in reaching financial freedom.