The 5 year adjustable rate mortgage (ARM) has emerged as a popular financing option for real estate investors looking to purchase investment properties. By offering a lower initial interest rate that adjusts after 5 years, 5 year ARMs provide more affordable payments during the critical early years of owning a rental property or flip. However, the interest rate risk after adjustment needs to be prudently managed. In this article, we will explore the pros and cons of 5 year ARM loans for funding investment property acquisitions, best practices for risk management, and alternatives to consider.
Payment savings from lower initial rates facilitate property acquisition
A primary benefit of 5 year ARM loans for investment properties is the lower initial interest rate versus traditional 30 year fixed-rate mortgages. Depending on market conditions, the initial rate on a 5/1 ARM could be 0.5% – 1% or more below comparable fixed loan rates. This discount reduces the monthly mortgage payment, increasing affordability and freeing up more cash flow for other investments. For real estate investors that plan to resell or refinance their property within 5 years, securing a lower initial rate can be an attractive tradeoff versus locking in a higher fixed rate for the full term.
Interest rate caps limit payment shock upon adjustment
While the interest rate on a 5 year ARM will fluctuate after the initial fixed period, most products contain periodic and lifetime interest rate caps that limit the maximum rate increase at each adjustment period and over the life of the loan. For example, a common cap structure is a 2% annual adjustment cap and a 5% lifetime cap above the initial rate. This prevents extreme payment shocks when the prevailing market rates change. Investors should crunch the numbers to model worst case payment scenarios and ensure their property cash flows can still support any future rate increases.
Shorter terms increase need for investor discipline
The abbreviated 5 year term on an ARM requires real estate investors to execute on clear exit strategies, either through a sale or refinance. Absent a new loan or property sale prior to expiration, the loan would convert to a fully amortizing product at potentially much higher rates. Savvy investors using 5 year ARM financing need the discipline to monitor market conditions and have contingency plans ready as the adjustment date approaches.
Interest rate volatility remains a key risk factor
While interest rate caps provide some protection, 5 year ARMs still expose investors to the risk of rising market rates over time. Investors backing their properties with ARMs should stress test their financial models at various interest rate assumptions to gauge the impact of increases. They should also maintain sufficient reserves and keep contingency refinance options open in case rates move against original projections. Portfolio diversification across fixed and adjustable rate loans could also help hedge interest rate risk.
Alternatives like 7 year ARMs offer more flexibility
Beyond the standard 5 year ARM, investors can also consider alternatives like 7 year or 10 year ARMs to get a longer initial fixed period for stability. The longer lock-in period reduces reinvestment risk closer to the horizon, while still offering a lower initial rate than comparable fixed rate loans. However, longer ARMs may come with tighter rate caps after adjustment. Evaluating all available ARM programs can help investors find the right balance of affordability and risk management for their needs.
The 5 year adjustable rate mortgage can facilitate investment property purchases by offering lower initial rates and payments versus fixed-rate alternatives. However, prudent investors need to manage interest rate risk following adjustment by budgeting for higher payments, planning exit strategies, and diversifying their capital stack across products. Alternatives like 7 year ARMs provide another option to secure a longer initial lock while still benefiting from an ARM’s lower starting rate.