Continuing on in our discussion of this financing strategy, today I want to talk about a pay option arm.  This type of loan product is new to many people.  I first learned about it a few years ago and the popularity of this loan has increased incredibly over the last couple of years with the high appreciation we’ve seen in many markets.

Now I’m not a mortgage broker, so I’m sure someone smarter than me could challenge me on some of the details.  I want to share what I know from experience and I will do my best to be completely accurate, but this is my disclaimer.  I have 4 of these mortages right now and will have more soon.  I’m not going to convert some of my properties to this type of loan because either A) they are commercial properties and this is not offered there, or B) I’m locked into 4.x% interest rates and am fine with keeping those loans in tact.

So what is a pay option arm?  Well, it’s an arm, ARM = adjustable rate mortgage.  This means your interest rate will change from time to time, and varies according to an index.  I don’t know all the details about indexes, but the fed (I think?) controls certain interest rates that are tied to economic indicators, like prime, LIBOR, MTA, etc.  You’ve probably been quoted interest rates that are something like “prime + 1″ which means your rate will be whatever the fed’s prime rate is, plus 1 more percent higher.  I have a business line of credit for one of my LLCs that holds properties like this.  So first you have whatever your variable rate is, then you are told how often your rate can change, and what the maximum rate you will ever pay is.  Let’s think of this as the “full” rate you would pay on your loan.  This is probably going to be 7.x% right now.

Then you have your “start” rate.  This is going to probably be 2% or so right now.

Now let’s talk about the “pay option” part of pay option arm.  Every month when you receive the bill for your mortgage payment, you will have options for how much you would like to pay.  Typically 4 options.  The bill will tell you what your payment would be for each of the options they give you:

  • Negative amortization: less than interest only.  ($470)
  • Interest only: you pay the full interest amount. ($683)
  • Amortized principle and interest payment: loan is amortized to be paid off by your loan’s maturity date, in basically equal payments. ($791)
  • 15-Yr principle and interest: loan has been amortized over 15 years, starting with your first payment and assuming your interest will not change the whole time. ($1,119)

You have the option to choose what payment out of the 4 choices you want to pay.  Of course the 15-yr option is going to have the highest payment, because you’re paying principle and interest amortized over only 15 years.  Your lowest option shows what you can pay if you utilize your “start rate” and make a payment that doesn’t pay what your full interest payment figured at 7.x% would be, but rather what the payment is figured at 2%.  I filled in what the payment amounts are on a pay option arm I have so you can see the relative difference between them.  Look at how dramatically your monthly cash flow is impacted by the payment you choose.  The 4 payment amounts may be different on every bill, because what you choose to pay each month causes some recalculations to occur.

A 2% interest payment is very low and your cash flow can be very high!

But wait a minute!  If you’re paying LESS THAN interest, what’s happening to the rest of the interest that you owe each month?  You guessed it.  That interest amount that you are deferring (the difference between 7% and 2%) is going to be added to your loan balance, essentially decreasing your equity for that moment.  If you had this loan on a property for 5 years, always made the lowest option payment (less than interest only) and looked at your loan balance at the end of 5 years, you would owe more on your property then than the day you bought it.

This scares some people.  In a non-appreciating market you are losing equity!  You need to look at how much in interest you are deferring over the course of a year (this amount is what’s being tacked on to your loan balance), and then compare this to how much your property is appreciating over the same period of time.  If it’s appreciating more than your loan balance is increasing, thus you are still gaining equity, you have to ask yourself if the strategy is worthwhile.  In my experience, it has been. 

I have pay option arms in highly appreciating markets, and I also have one in a barely appreciating market.  I’m ok with it because my payment on a 4-plex is only $470 a month and it’s cash flowing like crazy!  I’ll take the extra cash flow in my pocket now and worry about my equity later.  I don’t plan to sell this property anytime soon, so the cash flow is more valuable to me.

Tomorrow we’ll talk about the equity you need to have in order to get into a pay option arm and whether or not you want to go for one when you purchase the property or when you refinance it after the fact.