With interest rates expected to rise even further in the coming months, would be homeowners find themselves in search of options and solutions. For many, especially Millennials who’ve never experienced rising rates, this is a time of great concern when priority number one is to own a home. Because I am the father of two Millennials, their friends as well as my client’s children, look to me for guidance when it comes to matters involving real estate. Rising rates are not the end of the world. Rising rates are the result of rising inflation and inflation raises all asset classes including real estate. This notion that rising rates is the death knell of real estate is simply as my mother would say, hogwash. But there’s no doubt that rising rates do and should alter they way we view a real estate purchase.
I have been a homeowner for nearly 30 years. But it wasn’t until I locked in my rate at 2.5% two years ago, that I took a 30-year fixed mortgage. Literally, every home I purchased and subsequently refinanced was until two years ago a variable or “Adjustable-Rate Mortgage.” A 3/1 ARM, a 5/1 ARM, a 7/1 ARM even a 10/1 ARM. Why? Because I never saw owning my real estate outright as either desirable or viable. While for some this may sound controversial, for me it was logical. Allow me to explain.
The first thing any would be homeowner needs to understand is the concept of leverage. This is the power of owning real estate. Leverage means that regardless of my equity position, my home value is going to rise or fall irrespective of my equity in that property [Check out what your home may be worth here]. If I put 20% down on an $800,000 home, I put $200K down. If my home goes up by 10% it goes up 10% of the whole $800,000 ($80,000), not 10% of my $200,000 down payment ($20,000). This is leverage, and this is how wealth is created. Making money using other people’s money. So, it never made any sense to me to tie up a lot of money in my home beyond my required down payment. I didn’t start overpaying on my monthly payment until I was well into my 50’s, and this only because rates had gotten so stupid low. Until then, I reasoned I would rather use that extra money to generate wealth by buying more real estate and by investing and diversifying in equities.
Because of this approach I also never considered owning my home outright as a realistic possibility. I simply saw myself as a renter but with the advantage of having an equity position in the property and a beneficiary of its inevitable appreciation. Using this thinking, all I cared about was getting the lowest cost to finance. Admittedly, this took place during a multi decade period of declining rates. But my first ARM was 6.5% while fixed were in the high 8%’s. I always figured when the adjustment time came I would either accept the stepped-up rate or I would refinance into something else.
If you are unfamiliar with how these variable rate programs work, then allow me to elaborate. When you take a 3/1, 5/1, 7/1 or 10/1 ARM, what you get is a low introductory or “teaser” fixed rate of a shorter duration of time ie: for 3, 5, 7 or 10 years, then the balance of the loan is adjusted every year. That’s the “1” in 5/1 [Find us on socials here]. This contrasts with a traditional 15 or 30-year fixed where the rate and payment are unchanged for the loan’s duration. Variable loans are usually fully amortized, though you can get one with a balloon payment at the end of the fixed period. I’m not a fan of these as it can put you in a compromised position should rates be too high for you to qualify to refi or if values dropped below the threshold for your minimum loan to value ratio (ie: your 20% equity position had eroded) or worse if you’ve lost your job and simply can’t qualify for any loan. Then with a balloon payment due you’re forced to sell regardless of market conditions and simultaneously lose the roof over your head. But a fully amortized loan means that by the end of the term of 30 years, even if a variable rate program, the loan is paid off in full and that you never have to re-qualify. What makes this an ARM is that it’s only fixed for a specific period of time and then the loan will adjust annually.
Variable rate loans are comprised of a couple key elements. The first is the index. The index can be from a variety of sources. The London Inter Bank Offered Rate often referred to as LIBOR which adjusts annually can still be found but it’s replacement SOFR is more common since it adjusts every 6 months. The 11th District Cost of Funds is another index you’ll find and has traditionally been the best in times of rising rates because it is slow moving. And then there’s the 1-year US Treasury rate. These are essentially the rate a bank can borrow money at, their cost in other words. Then they tack on what called the “Margin” or margin of profit and this can vary from lender to lender, and this is definitely a number you must pay attention to. The combined total is the “fully indexed margin” and is the rate that your monthly payment will be based on for that year. This process will repeat annually so long as you keep the loan or until paid off.
There are a couple other key elements of this program you need to understand, but both are awesome.
The first is the rate cap. That’s right, an ARM has a lifetime cap. This is typically 5%. If rates go to the moon, the most your rate can ever grow to is the start rate plus the 5% cap. So, let’s assume you have a 5/1 ARM starting at 3.5%. Your lifetime cap means you can’t exceed 8.5%. The second element is the annual cap. This is typically 2%. If rates jump to 7% and you started at 3.5%, your 2% annual cap stops you in year 6 at 5.5% (3.5% + 2%). Since rates fluctuate, I have had this happen only to have it go down in year 7 because the Fed reduced rates in my adjustable year. And many times, rates only rise slightly so the 1-year adjustment may only be a ¼% or ½%.
You can see that an ARM is not as secure as a fixed rate mortgage. So why would someone take a variable loan over a fixed? The answer as I said at the top, is to reduce the cost to own. Why take a 5% rate when you can get a 3.5% for the first seven years? Even if it adjusts to the cap in year 7, you’re only at 5.5%. Take the monthly savings and address the change when and if it ever happens. You still pay off the loan in 30 years if you want, but for many the key is getting in and to stop paying the landlord’s mortgage off [Contact us here]. Also, 30 years is a long time and even with the latest data indicating people are staying in their home for 11 years before selling, 11 years is still not 30. Bottom line is that most people never keep their mortgage to fruition. So why take a more expensive 30 year mortgage rate when you can immediately save money using an ARM, there’s no guarantee the ARM will be higher when it finally does adjust and even then there’s a cap, it’s fully amortized should you stay 30 years and when there’s a good likelihood you’ll end up moving before you use up all the savings created by the low introductory rate?
What this all means is that rising rates aren’t the end of the opportunity to own and through leverage create wealth, rather that you need to adjust the way you view your real estate financing, that’s all.