Adjustable-rate mortgages (ARMs) have gained popularity among real estate investors in recent years due to their lower initial interest rates compared to fixed-rate mortgages. However, there are some key factors to consider when deciding whether an ARM is suitable for an investment property purchase. This article will examine the potential benefits and drawbacks of using ARMs on investment properties to help investors make an informed financing decision.
ARMs offer lower initial rates but carry interest rate risk
The main advantage of ARMs for real estate investors is the lower initial interest rate compared to fixed-rate loans. This lower rate results in lower monthly payments in the first few years of the loan, improving cash flow. However, after the initial fixed-rate period, the interest rate becomes variable and may rise significantly. This introduces uncertainty in future costs and cash flows from the investment property. Investors must assess whether the initial savings outweigh the long-term interest rate risk.
ARMs allow greater leverage but may reduce loan stability
The lower initial payments of an ARM enable the investor to qualify for a larger loan amount and leverage a bigger property purchase. With a fixed-rate loan the debt service is higher, limiting purchase power. However, as rates rise over an ARM term, the higher payments and tighter debt service ratio could disqualify the investor for loan renewal. This may force a distressed sale of the property to pay off the loan.
ARMs provide flexibility but have prepayment penalties
If rates fall over the course of an ARM loan, the investor has the flexibility to refinance into a new fixed-rate loan and lock in a lower rate long-term. This flexibility can be advantageous in timing the real estate cycle. However, ARMs often have prepayment penalties that deter early refinancing. Investors must model the cost of any prepayment penalties against potential interest savings from refinancing.
ARMs suits short-term holds but add risk to long-term buys
For real estate investors pursuing a short-term buy, renovate and flip strategy, ARM loans allow them to maximize leverage and cash flow during the holding period, before selling and repaying the loan. However, for long-term buy and hold investors looking for stable cash flow, fixed-rate financing reduces interest rate uncertainty over decades of ownership.
In summary, ARMs offer real estate investors lower initial rates and payments to improve affordability, but carry long-term interest rate risk. Investors must weigh up these pros and cons against their investment strategy and risk tolerance. Conservative investors favor fixed rates for long-term holds, while ARMs suit highly leveraged or short-term flip strategies.