Types of Mortgages
Whether you are looking to flip or buy/hold/rent real estate, chances are that you will run across a need to borrow money. As mentioned in “Low Money Down”, there are many different types of mortgages and money lending options out there. Here are a few:
Adjustable Rate Mortgages
Adjustable Rate Mortgages (ARMs), also known as variable rate mortgages, have interest rates that potentially fluctuate over time. For example, a “5/1” ARM is a loan that is fixed for 5 years but adjusts yearly after that initial 5 year period. A “5/5” ARM is sometimes available, which is also fixed for the 5 years but will only adjust in 5 year increments after that. This could be good if interest rates are gradually increasing, but if you get stuck in an interest rate spike, it could take you 5 more years to get another chance to adjust the interest rate to market levels.
There are usually limits on how much the interest rate can increase and with most ARMs there is an eventual ceiling so the interest rate won’t increase unbounded. Check with your financial institution to ensure that interest rate cap (i.e. upper limit) is in place since it is not a requirement for the bank to cap an ARM. Overall, ARMs introduce a great deal of volatility into your real estate investment and could change your positive cash flowing property into a negative one in just a year or two. Caveat emptor!
15/30 Year Fixed
There are a number of ways you can borrow money, and many different types of mortgages, but most of us are going to choose the traditional bank route first. Banks lend cheap money and typically have the most reasonable terms. Favorable conditions from banks are usually due to good credit, so keep that in mind before going the traditional bank route.
The most common and popular loan will be the 30 year fixed mortgage. Fixed means that your interest rate is going to stay the same for the entire life of the loan. The longer your amortization period, i.e. loan length, the lower your payments will be but you will end up paying more interest over time. It’s often very difficult to cash flow with anything other than a 30 year period since the payments will be so high with a 15 year period. 15 year loans have an advantage in some cases since your property will be paid off quicker and you’ll pay lower interest in the long run, but high payments and little (or negative) cash flow will put you at greater risk if the property has too many vacancies.
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This mortgage is likely to sound the most favorable out of the other options out there. The truth is, you are right in thinking that. The sad reality is that some banks will have issues doing fixed rate mortgages for investment properties, especially commercial properties, i.e. properties with more than 4 units. Fight for that fixed rate mortgage, but also remember that all is not lost if you can’t get one. You will need to look at the alternatives, assess your risk, and figure out what works the best for you to meet your investing goals.
A balloon mortgage is a loan that typically has a fixed term for 5-7 years but is amortized over a period of 25 or 30 years. Balloon mortgages can have lower interest rates and monthly payments than fixed-rate loans, which may make them attractive to some. The risk is that after 5-7 years, the entire balance becomes due–in other words, the balloon pops! Some may allow conversion to a fixed-rate loan at term’s end, but if no agreement was made for this, you could still go and try to refinance with the same bank or another one of your choosing. As with ARMs, the risk here is that your refinance could give you a less favorable interest rate than you originally would’ve had with a 30 year fixed mortgage. Another risk is if the real estate market takes a temporary dip again, you could be underwater during your refinance application and get denied.
Interest Only Mortgage
I highly doubt if any bank is going to allow you to do this at all, especially for an investment property. Back before the housing crash, these types of mortgages were cropping up to get even more unqualified people signed up with loans to stimulate the mortgage backed security market. It is highly recommended that you avoid this one. Although payments are very low, no equity is going towards the property. Unless you come in with a lot of money down, you could easily end up underwater with the property if the values decline. Worse yet, the interest only period is typically only 5 to 10 years. Once that period is over, you are either hit with a balloon payment or inflated future payments to make up that principal that was never paid in the first 5-10 yeras.
Contract “Subject To”
A Subject To is when you paying a seller’s existing mortgage “Subject To” the existing mortgage agreement with the bank. Generally, the seller is giving you the deed to the property and having you make payments on the loan, but the seller is still “assuming” the loan. Now the word “Contract” in this type of financing is very important since you and the seller will need to agree on the terms of conditions for this type of arrangement. What if you don’t pay? What if the seller goes bankrupt?
Subject To agreements are complex and deserve further research outside the scope of this article. CREOnline has a great article on Buying a House Subject To.
These are just a few of the different types of mortgages and loans out there for real estate investors. Investors have used all types of these loan arrangements and have had successes and failures with each. The important part is that you look at all of the options available to you, do your homework, and get the facts from your lender. If your real estate deal is good enough, the money will come!