5/1 Option ARM Advantages and Disadvantages

We have just puchased a new house which has a 30-yr Fixed loan. But our old house which we planned to sell did not sell. I am now stuck with 2 mortgages that I cant afford.

I am thinking of getting a 5/1 'Option' ARM of $249K on the OLD house. I plan to refinance after 3 yrs.

People tell me its a very risky loan. What do you advise. What should I watch out for.

1 Answer

Congratulations on your new home purchase! It must be a very exciting time for you. However, it is unfortunate you were not able to sell your home, receiving capital gains and getting rid of an extra mortgage payment.

Before you start trying to decide what mortgage is best for your payment and equity objectives for your new property, you must answer some questions.

Here are some sample questions you should consider:

  • How long am I going to keep this house for?

  • Am I renting this home to a family?

  • What are the rents going for in the area?

  • Is my financial mindset conservative, mid-aggressive, or agressive?

  • Is my income going to decrease, stay the same, or increase in the next five years?

  • What payment do I feel comfortable making if I go negative cash flow with the rental income?

Since you did not provide much detail to your question with objective, I am going to assume you are renting that house. I would suggest to do some research with monthly rents so you can get an idea of what the rents are going for in the area. This will give you a better strategy to select a mortgage that will help you minimize negative cash flow.

If I were you, I would also consult with your CPA to ask about any non-owner occupied properties tax deductions. This will allow you to select a program that will allow you to maximize tax deductions. Your net taxes payment savings will be ideal and to your benefit.

The 5 year pay option ARM is an aggressive program designed for those borrowers that like cash flow and leverage. What do I mean by this? These borrowers really can afford the fully amortized payment with the full index rate, but choose to make the minimum payment because they choose to invest those savings in some high yield liquid vehicle where the rate of return is usually higher than the fully index rate they are paying on their mortgage.

There are risks to this type of loan, but it also has some big rewards if used to your advanatage. If you only make the minimum payment then you are risking your property to go negative amortization. The difference between the Interest Only and Minimum Payment, also known as defferred interest, gets added back to your mortgage balance. This only makes the loan more expensive causing many borrowers not being able to pay the loan as the payment continues to increase. It may also cause people not be able to qualify for a mortgage with the new higher loan amount.

If you are that type of borrower that knows how to take advantage of cash flow then go with that program. You will achieve the freedom point faster. If you are not and plan to refinance in three years and plan to keep it for more than five years, but like to play the "rate game," then go with an interest only product (i.e. 5/1 LIBOR I.O., 7/1 MTA I.O.).

I hope this helps you as you are in the search for a good mortgage program for your investment property.