ARM vs. fixed: which mortgage is best for property investments?

Written on February 20, 2018 by

communicationCongrats, you’re getting an investment property! That’s exciting stuff. Right now, you’re probably thinking about leases, marketing strategies, and whether the property needs revamping.

Before all that, you should think about the financing. No, it’s not as exciting. But, what is fun is profit. By making sound mortgage decisions, you’ll have greater profits and better cash flow. If you’re not getting an investment property for profits, then why get one?

Mortgage decisions aren’t easy, especially when it comes to investment properties. You want to choose the financing that costs you the least amount of money. To do this, think through your investment strategy to the end. Here’s what to consider when making a mortgage decision:

  • How long will you keep the property?
  • Will there be more cash flow with one mortgage over another?
  • Do you need multiple mortgages?

To make a good financial decision, think about what makes the most sense for the lifetime of your investment.

Related: A beginner’s guide to buying a rental

What’s an ARM?

An Adjustable Rate Mortgage (ARM), has a fixed rate for a period of time. After that pre-determined time period, which is usually one to five years, the interest rate adjusts. ARM terms can vary widely, but once you know the lingo, it is easier to understand.

  • 2/2/5: The first number indicates the percent the interest rate can change in the first year the fixed rate ends. The second number tells you how much the interest rate can increase each year. The last number is the maximum percentage the interest rate can increase in the lifetime of the loan. If your first five years were at 5% interest, in this example, the maximum your interest would get to is 10%.
  • 3/1: The first number indicates the number of years your interest is fixed. The second number tells you how often the interest rate will change. In this example, the interest is fixed for the first three years. After that, it adjusts once a year on the anniversary of your mortgage.
  • Index: The economic indicator that calculates the interest rate for the ARM.
  • Initial Cap: This number tells you how much your interest rate can change after the fixed period has expired. Sometimes this number is the same as the periodic cap, and sometimes it’s more.
  • Lifetime Cap: The limit your interest rate can be raised over the life of your loan.
  • Periodic Cap: The maximum the interest rate can increase from adjustment period to adjustment period.

Property A using a 3/1 ARM

Property A has a 3/1 ARM. (As a reminder, that means three years fixed, and after that, the interest adjusts once per year.) The interest rate is at 5% (2/2/5). So after three years, the interest can go up 2% to 7%. Every year after that, it can go up another 2% until it reaches the lifetime cap of a 5% increase. The highest the interest rate will be is 10%.

In years one, two, and three, the loan is $80,000 with an interest rate of 5%. The principal and interest would be $429 a month.

After three years, the interest rate goes up to 7%. The principal and interest are $499 a month.

In year five, the interest rate goes to 9%. The principal and interest are now $591 a month.

In year six, the interest rate goes up to the maximum: 10%. The principal and interest are now $630 a month. Because your maximum is 10%, you have reached the maximum principal and interest payment in year six.

Related: Pros and cons of making extra payments on your mortgage

What’s a fixed-rate mortgage?

A fixed-rate mortgage is a simple loan structure that has the same interest rate for the lifetime of the loan. The benefit of this type of loan is there are no surprises. Unless your taxes go up, your payment will be the same for 15 or 30 years (however long you chose for your mortgage).

Property A using a fixed-rate mortgage

We’ll use the same example from above to show the difference. On average, ARMs start at an interest rate 1% lower than fixed-rate mortgages. For this example, the loan amount will be $80,000 with a 6% interest rate. The principal and interest payment will be $480 a month.

To compare the ARM VS Fixed-rate, let’s look at the example.

  • During years one, two, and three, you save $1,836 using the ARM over the fixed-rate mortgage.
  • In year four of the ARM, the fixed-rate mortgage saves you $228.
  • During year five, the fixed-rate mortgage saves you $1,332.
  • Year six, the fixed-rate mortgage saves you $1,800.

The fixed-rate mortgage saves you $44,760 over the lifetime of the loan.

Related: What to look for in a quality mortgage broker or lender

It’s not that cut and dry

Before choosing a mortgage, ask yourself these four questions:

  1. If you choose an ARM, can you afford the payments after the low-interest period is over?
  2. How long do you plan to keep the property?
  3. If you choose a fixed-rate mortgage, is the payment low enough to provide a cash flow?
  4. Do you need multiple mortgages for additional investment properties?
  5. Can you pay off an ARM in the fixed period?

Here’s where an ARM makes sense:

  • You plan to sell the property within the fixed-rate period.
  • Your cash flow isn’t enough with a fixed-rate.
  • You need multiple mortgages.

For property investors who need multiple mortgages, a portfolio lender might be the only option. Portfolio lenders don’t need to meet underwriting guidelines because they use their own money. Some portfolio lenders offer only certain types of loans, and those loans are often ARMs.

Before making a final mortgage decision, make a plan for your investment. Look at all facets of your investment over its lifetime, and make a decision. Then, it’s onto the fun part of property investing.

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