The guidelines on pay option arms are changing on a regular basis, so what I’m about to say may not be true 100% of the time, and across the entire gammet of credit scores, but this has been my recent experience anyway.  Because these arms use negative amortization, there needs to be some equity in the property to pull from each month when you make less than the interest-only payment.  That is where the bank is going to get the rest of the money to cover the interest that is due.  So far that reason, you generally cannot do these arms and finance 100% of the property at the same time.  I actually have heard that Bear Stearns will do this on owner occupieds now, but I certainly have not found anyone willing to do it on a rental.

So you need to have equity in the property.  Just how much equity?  Generally 10%.  On a non-owner occupied rental, the lender doing the arm will generally lend you 80% of the value of the house.  You can back that up with a second mortgage for another 10%, with the remaining 10% being pure equity that’s in the house for the arm lender to pull from. 

Remember back in my original post I was offering a strategy of only 5% down, not 10% down.  The idea is that when you buy the property you put 5% down in order to get into it with the smallest amount of cash.  You’re either buying it with at least 5% equity already in it (plus your 5% down makes the total equity 10%) or you’re buying into a preconstruction deal where you expect it to appreciate at least 5% during the build-out phase.  After you close on the property, you refinance into a pay option arm.  When you refinance, the lenders will lend based on the appraised value.  So you get the house appraised, and as long as it comes in high enough, you’re golden.  It may even come in high enough so that you don’t even need to get a second mortgage.  Possibly the outstanding loan you currently have on it will represent only 80% loan-to-value by this time and then your re-fi puts you into an arm and nothing else.  This is awesome because then your payments are even lower yet.  When you’re borrowing 80% LTV or less (70% LTV, etc.) you get bumped into a better interest rate category.  You have dual benefits: better rate, and only 1 loan instead of 2. 

Could you buy the property and get into a pay option arm right away, avoiding the re-fi?  Sure!  But that means you’d have to put 10% down out of your pocket at the closing.  Remember, the lender needs to have 10% equity there in order to pull from each month that you make your less-than-interest payment.  When you first buy the property, even if you’re buying way under valued, the lender will only lend based on the purchase price, not the appraised price.  So all that equity that’s there because you got such a great deal really doesn’t benefit you from this perspective.

Some will argue that avoiding the re-fi is worth putting the extra money down.  After all, you have to pay to re-fi, it’s not free.  Well, if it costs less than 5% of the value of your house, then you’re still paying less out of your pocket if you do the re-fi.  There are a couple of tricks with the re-fi that can make it even less painless, and that can improve your profits.  I’ll tell you about those tomorrow.