Ep 76 – Do Adjustable Rate Mortgages Make Sense in Today’s Market?

For quite a while now it hasn’t made much sense to even consider doing an Adjustable Rate Mortgage (ARM). Why have it able to adjust when you can lock in a 3-4% rate for 3 decades?

With a doubling in mortgage rates over the past 3 months, however, ARM loans might make a lot of sense for investors.

Adam Schroeder and Zach Lemaster discuss the two options, when it makes sense for both of them, and what you need to consider if you’re thinking about using an ARM.

Watch the Video Version Here

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Wealth/Rental Calculator

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Adam 00:22

Hey, winter tires, it’s Adam Schrader here with Zach Lawmaster for another podcast episode. And today we’re going to talk about that which has been all the rage amongst our, our clients since we’ve started adding it to our sheet and they’ve seen the massive increase in numbers that is looking really good. And that is adjustable rate mortgages. We’ve seen these become more popular as our investor loans have gone up 6%, which for the record, is not crazy. I actually have loans from several years ago that are higher than that. But we’ve seen them increase rents haven’t had time yet to catch up. So returns have been compressed. But now we have an adjustable rate option that we’re pretty excited about. So we’re gonna get into that today. But first off, hey, Zack, welcome to the show. Hi, Adam. How are you? I’m doing well. So you went out and interviewed, I don’t even want to know how many lenders to get this rate, because everybody I talked with was sourcing people who were doing adjustable rates. And they were saying, Oh, it’s, there’s they’re pricing them to be the same as fixed rates. And then you went out and talked to and you found a much better option. Can you tell us a little bit about what you found?

Zach 01:36

Yeah, absolutely. I think this just kind of big picture here, Adam. This is something we constantly do. We’re always looking for the best lender options. I mean, obviously, we’re all investors ourselves. And we personally want to use those loans, those best loan options out there, but also make them available to our clients. And not all lenders are created equal. I think that’s one thing that and people need to know is you really need to be doing your due diligence

in searching for the best lender. Now the lender recommendations that we have, we’ve already done that for you, you can still go out and source other loan options, of course. But we’ve done that heavy list lifting where yeah, sometimes it takes interviewing and getting quotes from 50 to 100. Lenders to see what kind of terms they have to offer the best investment products to offer the best cash flow. And we’ve seen a huge, huge variance, especially right now. I mean, kind of talking about where we’re at right now, with interest rates, it’s a little bit of a shock factor, right? Because people are seeing that interest rates are still creeping up, really what’s happening, or interest rates are just getting back to normal. This really is where interest rates should be. You know, I know it’s not it’s kind of painful to hear that for most people. When we over the past two to three years, we’ve all gotten very comfortable understanding and feeling like the norm is historically low all time low interest rates. And that became the norm at that point in time. But really what’s happening, this is a necessary thing is to get interest rates, normalized to where they’re at today. Of course, we have 40 year high inflation, the Feds trying to combat that but a 6% interest rate, you know, that is actually pretty good interest rate. If you look at overall historic averages, you can still cashflow 6%. Now, if you’re comparing it to, you know, three and a half to four and a half percent, you know, 18 months ago, obviously that’s that’s a big difference. However, it’s important to be an astute investor. And always look at what the best financing options are out there based on your goals, timeline resources. And so what we’ve done is offered an alternative found an alternative lender solution where you can do an adjustable rate product. And we’ll talk a little bit about what an arm means and what that entails. But we have arm products that we’re seeing people get as low as 3.75%. You know, that’s, that’s a significant drop or a property that maybe didn’t make sense at 6%. I think all of our properties still do based on the cash flow, but that does allow an investor to come in, be creative and be an investor that is using these creative options to still cashflow more in a period of time. So maybe let’s start and just review what an arm product is. Adam, do you want to give the bullet points and all in in the to my two cents on it as well? Yeah,

Adam 04:11

absolutely. So just so people know these terms that are on the website that you’re going to see at rent to retirement.com are all based from what I understand Zack we’re basing it on a five one ARM right?

Zach 04:23

Yeah, there are what we’re showcasing is a five will I want to say one um, so what that means it’s a five you actually have a locked interest rate. Whenever you hear an arm Usually you hear five, seven or 10 year ARM, it’s still amortized over 30 years. But that just means that the interest rate is only locked for that five year period. That is what we are showcasing and we’ll explain why. Now the second part of that is like five slash one the one part of that, that means that the interest rate has the ability to adjust every year. So if you see a five slash six, that means six months. Those are the most common two. So that just means the second number there’s just the adjustment period.

Adam 04:59

Yeah, so you’re seeing these, and they’re locked at that 3.75 to four and a quarter. So we just put 4% to hit the middle and kind of cover any variance that’s going to be there. But you’re

put 4% to hit the middle and kind of cover any variance that’s going to be there. But you’re

looking at that with the locked in rate for five years during that time, most of them don’t have prepayment penalty, so you can refinance out of it and get into a 30 year fixed if it starts to make sense. Or if it’s getting towards the end of your five year locked in, you’re worried about where it’s going to go up to, you know, then you can start looking at your 30 year fix. But I’m going to run some numbers by you here. And it’s going to show that it’s probably a pretty darn good option. If you are concerned about the current, you know, 6% Roughly rate that we’re seeing there. So I have two different properties that I pulled up. One is kind of your average property that we have it’s 150,000, let’s say 157,000 price point. And then another one in that one’s in Missouri, and this other one is a $212,000 property that’s in Central Florida. So when you look at the numbers, I am using a 2% rental increase, which right now in today’s market is absurdly low. But it is something that I think anybody could get pretty much any year.

Zach 06:17

That’s a very conservative number. Yeah, in especially in the Florida market, we’ve seen a 22% increase in rents. Now that may not be sustainable, but 2% just for if someone wants to be ultra conservative. Yeah. 2% increases over time. And just before we go into the numbers real quick, the whole idea. I mean, the question with the arm is okay, well what happens at year five, right? I mean, if the interest rate, what happens at that point is the interest rate can adjust.

And usually it’s there’s a ceiling or floor to how much it adjust, we all anticipate rates to be higher. But if the rates are lower, I mean, the rates would lower at a step down, right. So if it’s if it’s a 1% ceiling, you know, if rates are at 8%, and you’re currently at 4%, your rate would go up to 5%, the next year, and then the following year, it adjusts again, but really, I think the point we’re trying to make here, Adam, is that because over that five year period, because of rental increases over time, your your cash flow should well support. Whatever the interest rate is, at that point in time, it really shouldn’t be a concern, if you hold that loan, other options are potentially doing a refinance, if there are significantly better rates at that point in time, or possibly selling and doing a 1031 exchange on the property, the average holding time for a lot of our turnkey investors is between four to six years. And that’s just simply because it makes sense to sell the property at that point in time because of rental increases in time. But really the the appreciation, the equity position you have through appreciation and debt reduction is significant enough that you could sell that property, still early enough before you have huge capital gains, say in your 10 to 15, potentially, or I’m sorry to say capital gains capital expenditures with like roof and things like this. So it’s kind of the sweet spot to sell it, you have enough equity to go out and exchange and buy more properties. That’s often what we see. And so you may not even need to worry about it. I use arms all the time. And I have for a long period of time, I currently have arms right now, this is just something we need to be aware of. Whereas in the past two to three years, no one cared about it, because your conventional rates were, you know, just as good as an arm product. So it’s like, why would you even explore that. But these are a very viable options. So let’s go through some numbers, Adam.

Adam 08:24

Yep. All right. So we’re gonna start with the the turnkey rehab in Missouri, it’s 157,000. It’s got a rent of 1250 on the property. And so like I said, I’m using a 2% rental increase. So that means every year and I’m not going to compound it by year, but every year, you’re raising your rent roughly $25 a month, as I tell people all the time, if your tenant is going to leave over $25 a month, you probably don’t want that tenant to begin with. That’s not somebody you want to

keep in place, and probably not somebody who was going to get approved for the for the rent in the first place that your property. So you’re going up $25 A year, you’re looking at five years. So that’s $125 a month that your cash flow is going to go up, roughly. And that time, obviously taxes can change insurance might change, but you know, just call it $125. But here’s the thing. Every month, when you look at the 4% versus 6%, you are getting an additional $154 a month in cash flow, which takes your cash on cash from 7.3 all the way up to 12.2. And so over those five years, you are getting an extra $9,240 a month in positive cash flow without factoring in the rental increase. So you’re already day one even if rents stay the exact same. You’re going to be over $9,000 ahead. Now, when you refinance You’re not going to be paying $9,000 In closing costs on your refinance. So no matter what, you’re still ahead, you’re going to be pulling money out anyway or selling. So it might not even matter, but you’re not going to have a $9,000 closing on it. And so you’re going to be in a very good position, you’re going to be ahead one way or another in this deal with your arm. So that is, that’s step one, I would say. And the other one, like I mentioned, is in Central Florida, 212,000 rents for 1650. So at 2%, you’re looking at an ad a $33 increase every month, once again, that’s not enough to make somebody move. So you’re looking at $165, over five years roughly, and rental increases, but in this one, your cash flow is actually bumping up $208 a month. So now you’re ahead 12, that might make a whole lot more sense. And, you know, put you in a better equity position moving forward.

Zach 11:03

Yeah, those are those are good numbers to look at. And anyone that’s looking to explore this option, I highly encourage you just for educational purposes to to write out the numbers, we have a good calculator on our site that shows rental, you can plug in whatever appreciation rental increases you want, over time, it shows you year or month by month really what that would would look like and year after year to help you run those numbers. But I think the point you’re making big picture is that even if rents stayed stagnant, by having a lower interest rate at called 4% on an arm, your cash flowing significantly more give or take in that $10,000 range over that five year period, which is which is significant. But then we assume, of course that rents will increase over time, especially in this inflationary environment, rents are absolutely gonna go up in all markets that we invest in. And so your cash flow should be higher than the potential change in interest rate will affect the mortgage. And so your your cash flow, if you were to hold that loan and allow the adjustable rate to come in, on a yearly basis, you should be just fine. If you run the numbers looking at that. And again, you have other options to look at you can potentially refi if say interest rates are much lower, I mean, your your rate would lower with that as well. That’s the thing with the adjustable rate, it could go up or down. So I don’t know if refinance refinancing would even make sense. But more realistically, probably within that five to six year timeframe, you’re likely going to look at selling it and doing a 1031 exchange. So it may not even matter. And quite honestly, that’s why I buy a lot of products with arm loans, because we simply our exit strategy is not to hold it for 30 years. I mean, the 30 year fixed loan is something that’s very unique to the United States. I don’t think a lot of people know this, but I’m not aware of any other country that offers a 30 year fixed. We own property in Canada, my my wife’s Canadian. So I mean, they don’t have a 30 year fixed products, they’re all of their product, this is the norm, they have an arm product with a lock period. This is how commercial lending works in the US, there’s no such thing as a 30 year fixed rate. They’re all along on balloons, and it could be fixed for a period of time and then adjust or that a balloon, you know, some term of the loan. So I don’t I just think a lot of investors maybe

haven’t explored the arm option or really don’t understand it. And they hear the word adjustable rate. And they get concerned with that just because they’re unfamiliar with it, but relaxed to 2007 2008.

Adam 13:28
Whenever you had the people who were in the really they leveraged themselves too much

when the adjustable rate came in, you know, it hammered him, but

Zach 13:39

you know, oh my gosh, and those, and those Adjustable Rate products at that point in time, were just outlandish. I mean, it was, you know, you could have a rate adjusting every three to four months, or six months, it was it was just crazy. And when you’re buying a house that doesn’t cash flow in the first place, you know, that had doesn’t have any equity, and just banking on the fact that it’s appreciating. I mean, that just doesn’t make sense to any degree. So yes, there’s definitely probably some negative connotation from that experience with adjustable rates. But, I mean, the Feds don’t even allow those products anymore.

Adam 14:11

Yeah, we’re, it’s a whole different ballgame. I know, they say, you know, this time, it’s different. And that’s the famous last words but the lending world is actually fundamentally different this time around because of what happened previously. And so I mean, when you look at the you know, if you just factor in maybe a 3% appreciation in your property by the time you get around to year five you know, you’re going to have you know 20 $30,000 in equity in the area of appreciation on the property let alone your equity pay down and you’re going to want I mean, no matter what, in my opinion, I mean I’m, I’m at that point with some of my properties where I’m looking into refine because it just makes a ton of sense even into a higher rate with my properties because I don’t care about that. You know, I’m looking at it will still cash flow though I’ll be able to get money out. So you’re going to want to do something, I mean, even if you keep the property by the year five, you’re going to want to do something with that property one way or another. And that’s going to involve changing the loan. And at that point, you can just change it, and then move forward from there. So by the end, he didn’t even mind. Yeah, even

Zach 15:24

in 6%, if you did want to hold a 30 year fixed loan, I mean, here’s the reality. Most people are not holding their property for 30 years and paying off that mortgage, that’s just a reality. I have some people come into this with the mindset, like I’m gonna buy this property and just own it forever.

Adam 15:38

And the real estate investing is done.

Zach 15:42

I mean, that’s, you know, that’s the mindset some people have. And and I understand that, and in some cases, maybe that is true, in the vast majority of cases, people are not holding their properties that long. And the typical holding time is four to six years, we’ve seen and that’s, that’s typically what we hold as well, because you got to keep your money dynamic. If you have equity in that property. You know, maybe it makes sense to position that money into the next up and coming market. And I mean, that’s really how you grow your net worth over time is keeping your money dynamic. So I think really, the argument is, do you Would you ever even have Is there any point to ever have a, you know, a 30 year fixed loan on a property in the first place. And I think there’s a lot of argument out there to be had that that really doesn’t even make sense. You know, as far as looking at your closing costs, and things like that, often arms can be, unless you’re paying points, I mean, they can be less expensive as well closing, which at the higher price point makes makes a big difference as well. But it’s just something I would encourage everyone to look into and kind of understand also, interest only people hear interest only options, and they, you know, really don’t understand that. But they get concerned when they hear interest only. Well, if you look at a 30 year amortized loan, you’re it’s mainly interest only in the first years anyway, you know what I mean, you’re really not paying a significant amount of principal down, just because banks front load that interest. So I mean, those are just important things to look out, I think the arm is a very viable product. But also with where we’re at in the economy right now, rents are increasing dramatically. There’s all time low supply, or all time, low supply, all time, high demand. I mean, people need housing, especially in certain parts of the country, rents are appreciating dramatically and going up. So I think even if you’re at a 6%, usually, when you’re looking at a pro forma, that’s, that’s your one analysis. And so year 2345, down the road, as rents increase, your mortgage won’t change. And so your cash on cash return should be getting better year after year, as well as that property appreciating loan being paid down, and things like that. So those are important things to consider, year after year performance, not just looking at your one.

Adam 17:47

Yeah, I mean, I track my cash on cash monthly with my spreadsheets because I don’t nerd like that. And most of my properties, you know, at the four or five year mark, our cash on cash somewhere in the 30 to 40 range, I mean, even factoring in the monthly mortgage payment and all of that, I mean, it’s, it’s getting, you know, every month, it gets better, and then there’ll be a little, you know, repair, that’ll knock it down, you know, maybe quarter of a percent, half a percent. And then it just continues climbing, I can throw out, you know, I was telling you about an example of a property that I’m about to refinance out of, and I’ll, I’ll throw this out here before we start, but this is kind of a something for people to keep in mind when they’re looking at their long term plan. I have a property, it was the cheapest property I’ve ever bought. You could not find this property now. It was a turnkey property in Memphis for $53,000. Obviously, not in the greatest of neighborhoods, but turnkey property in Memphis, $53,000. Thanks, it would it was appreciating before COVID, it was probably around, you know, gotten up to 70,000 or so. And now with COVID. It’s looking like it’s probably somewhere around 110 to 115, somewhere in that range. And so we’re looking at and our interest rates somewhere around five and a quarter. And so this was five years ago, people so if even if it just goes to regular, you’re going to be in that five to 6% range, most likely in the in five years. And so we’re looking

And the real estate investing is done.

at potentially pulling out. Remember, this was 20% down so we had $10,600 into this deal. We’re looking at potentially pulling out $45,000 from this property, and still cash flowing 150 to $200 a month. I mean, when we first started our cash flow was about 250 a month. But because of rental increases, because of appreciation, we’re able to position ourselves in a much better place than you would have looked at you know, year one.

Zach 19:52

I love that and that just goes to show I mean how you can compound real estate over time. Really, this is this is a long game. I mean just holding Real Estate in, you know, really looking at every year reevaluating where your property’s performance is at. I mean, you just hold a property for four or five years, you have enough equity to then pull out there is such a thing as return on equity. And so you need to make sure that you, you know, that’s, you’re using your equity strategically. And so in your case, that property, your f class property in Memphis in the war zone, I’m just kidding. Yeah, but you can’t get those prices today. But some people would argue Memphis doesn’t appreciate, you know, but I mean, that’s, that’s the reality is everything’s appreciating right now. And so that type of property, obviously, it’s still cash flow, and quite well, even with a refinance, but even with higher interest rates, and you’re pulling out equity, then go get a return on an on your equity, scaling up and buy more real estate. So that’s a perfect example. I love that, Adam.

Adam 20:48

Yeah. And if the five one makes you uncomfortable, you know, like, Zack was saying, there’s a seven, there’s a 10 year, you have the option, obviously, those will be slightly higher interest rates, but you can lock it in longer make asleep, if it makes you sleep better at night

Zach 21:04

numbers, run the numbers on it and see what see what makes sense, say if I plan to hold this property for five 710 years, or whatever the case is, because it’s likely not going to be 30 years. You know, what, what makes sense at that point? I mean, what are the potential options that may help you plan your disposition and exit strategy on the property as well, which I think a lot of people don’t necessarily have that foresight. Again, it’s like I’m going to buy and forget about it, which is, which is great. You can forget about it for a certain period of time. But you need to re evaluate if that property if you’re in an up and coming area in the path of progress, and that property is appreciated significantly. Yeah, maybe it makes sense to sell sooner. I mean, we’ve had some people that have turned around and sold properties in areas in one to two years and done exceptionally well just because of the appreciation. And then they went and bought three or four more properties in 1031. It so definitely something to consider. I encourage everyone to look at an arm product. And it is a creative way to increase cash flow now increase your overall returns and combat the higher interest rates that we’re seeing currently.

Adam 22:01

All right, well, I think we’ll stop it right there. Everybody, you can check us out at rent to retirement.com That’s rent to retirement.com you can schedule a call with a strategist to talk

retirement.com That’s rent to retirement.com you can schedule a call with a strategist to talk

over these things. If you’ve got a portfolio with a bunch of equity in it, we can figure out how to strategically deploy that equity. That’s all at rent to retirement.com If you have any questions you can email us podcast at rent to retirement.com That’s podcast and rent to retirement.com would appreciate you going to whatever podcast platform you use.

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