Rising Mortgage Rates Are Hurting Your Investment

The 6 month LIBOR ( a popular 5/1 ARM index) has gone up 274% in the last two years. The inverted yield curve causes long term rates to be better than short term rates. The net effect is that your real estate investing career is impacted dramatically and directly. Two years ago you could buy a $140,000 house with 100% financing on a 5/1 ARM, rent it out for $1,100 a month and have positive cash flow.

Those times are over for right now. Interest rates have gone up, but rents have not. This means that if you buy that same $140,000 house now, getting the same $1,100 a month rent, that you are going to pay some money out of your pocket to make up the difference between the mortgage and the rent. This is called an alligator, because you have to feed it.

Second mortgage rates on high Loan to Value loans (above 90%) on real estate investment properties can go as high as 19%, even if you have a 700+ score. First mortgage rates run in the 8s at the moment. You are not going to cash flow if you are paying full market value and getting 100% financing.

Rate Cheating Thinking

A good credit score is not enough to help you cash flow, structuring the deal right is now more important than ever. Understanding your financing options can make the difference between having a positive cash flow and having an alligator. Here they are:

Strategy #1 Beat the rate down

When you get your financing to purchase a property, put at least 10% down. At 90% loan to value, and documenting your income, you have a standard Fannie Mae/Freddie Mac loan with rates in the low 7s (and in some cases still in the 6s). You need to have a 620 credit score or better, be on your job (or self employed) for two years or more, and have 6 months of reserves in assets. (Reserves are calculated as the new mortgage payments multiplied by the number of months). Reserves can be in the form of 401Ks, IRAs, stocks and bonds or cash.

Strategy #2 Buy right and then refinance immediately after

Your goal is to have the loan not exceed 90% of the value of the property. On purchases the purchase price is used to calculate the loan to value (regardless of the appraised value), and on refinances the loan to value is based on the appraised value of the property. If you buy the property at a discount, say 65 cents on the dollar with hard money, cash or conventional financing, you can refinance immediately after.

The refinanced loan can be based on the appraised value which will lower your loan to value and allow you to qualify for the best rates. The key here is to buy the property at enough of a discount so that the new loan plus closing costs will give you a far better rate than if you purchased with 100% money. The side benefit of this transaction is that you can get your entire original investment back, you can even get cash out, and still have a payment low enough to cash flow positively.

Strategy #3 Base the mortgage product on your exit strategy

If you are a buy and hold real estate investor, then get the longest term product available. Right now 30 year fixed loans are cheaper rate wise than 5/1 or 3/1 ARMs. Sometimes you can opt to choose a pre payment penalty which will reduce your rate further, or choose to pay extra points. Only use these options for a long term buy and hold strategy. If you dont know when you are going to sell, use the 30 year fixed option.

If you plan to hold the property for two years or less, and/or your selling method is a lease purchase strategy, then you can cash flow much more every month if you use an Option ARM. It can cause negative equity if you choose the minimum payment option every month, but if you have equity in the property and sell in a relatively short amount of time, this loan can be very valuable to your cash flow since the minimum payment can be as low as 1.5%. You also have the option to amortize over 40 years which lowers your payment even further. It is a terrible long term loan however, so make sure you can get out of it in a short amount of time.