Financial Strategies For Investors To Consider: This Will Be More Than Just Two Cents Worth
Welcome back, this is part 2 of the saga called, “Financial Strategies For Investors To Consider”. We have covered a lot of information thus far in part 1.
For those you that might have missed it, you are in luck.
Financial Strategies For Investors To Consider: Lets Talk About Speculators
What about the speculators? People buying for 3 to 5 years. Well, the negative amortization Option ARMs are extremely popular.
I’m not a big fan of Option ARMs because they’re risky and largely misunderstood by those who get into them. The big attraction the low initial monthly payment but that’s balanced by the resulting negative amortization and an interest rate that’s variable from the very first month.
Financial Strategies For Investors To Consider: Advantage Of ARMs
Anyway, they do have advantages for speculative real estate investors because they make it more possible to have positive cash flow on investment properties.
So we should really take a moment or two to fully understand how they work. First and foremost, the initial payment is an artificially low payment.
In many cases, it’s based on a 1% interest rate but that definition is based more on marketing than reality. Fact is; the minimum payment is less than the accrued interest so the mortgage balance goes up every single month.
Financial Strategies For Investors To Consider: Disadvantage Of ARMs
This minimum payment doesn’t stay the same forever. It’s fixed for the first 12 months and after that, it increases by 7.5%. Then it’s fixed for another 12 months and increases by another 7.5%.
The minimum payment increases by 7.5% each year for the first seven years OR until the loan balance has reached its ceiling. Depending on the program, these loans can grow to either 110% or 125% of the original loan balance.
Actually, the ones that can go as high as 125% are becoming increasingly rare. Most will only allow you to go as high as 110%. Anyway, once you’ve reach that ceiling, the loan starts amortizing right away – and that means a BIG payment shock at that point.
Financial Strategies For Investors To Consider: So What Does That Mean
For obvious reasons, these loan programs are only justified if the real estate market is appreciating FASTER than the loan is growing. Although it depends on where interest rates go, most of these loan programs grow by 2% or 3% each year if you only make the minimum payment.
So if the real estate market is appreciating faster than that, you’re still building equity. If not, you’re losing money every month. That’s the scary part. If it ever comes to that, you actually SAVE money by selling today – unless you’re okay making the larger interest only payment.
And don’t forget the interest rates on these programs are variable so the interest only payment can be different each and every month.
Financial Strategies For Investors To Consider: Possibility To Finance More Than Traditional
But we also have to keep in mind that these loan programs will only go as high as 95% financing. In fact, on investment properties, some lenders won’t even go that high. Depends on the lender. Also, the 95% financing is generally split into two separate loans.
The 1% start rate loan usually only applies to the first 75%. The 20% second mortgage makes up the difference and is usually a fully amortizing loan with a much higher interest rate.
Sometimes, you can do an 80/15 but most are 75/20s. So that means you have to come up with at least 5% down payment to qualify for one of these loans. That makes it more difficult to buy more and more, unless you continuously refinance and take cash out of other properties.
Financial Strategies For Investors To Consider: Key To Increase Rate Of Success With Them
The speculative investors who use these programs are trying to keep their properties cash positive, or as close to cash positive as possible. But as we discussed a moment ago, the payments rise by 7.5% each year. After three or four years, the payment will be 24% or 33% higher (respectively) than it was at the beginning.
If the market is still appreciating strong at that point, the investor may want to keep the property for another three or four years and refinance into another identical loan product, bringing the payment back down to the initial 1% point again.
Doing so would increase the negative amortization but it may also keep the cash flow positive on that property.
Financial Strategies For Investors To Consider: Stay Tuned For Part 3
Be sure to look out for part 3 of “Financial Strategies For Investors To Consider“. Also feel free to comment your thoughts on what you have read thus far.
Take Care And Have A Great Day
Dr. Gregory Stargell II
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