Leah Collich: Hey, everybody. I’m Leah Collich with RealWealth, and I’m joined today by one of our preferred lenders, Caeli Ridge at Ridge, at Ridge Lending Group. I’ve asked her to come on today because all of us investors who work here at RealWealth are putting our heads together about what makes deals work today, and we’re all in agreement that it’s probably in your best interest for us to be advising you to use adjustable rate mortgages.
These suggestions are often met with a little bit of pushback, and we think it’s just people don’t understand this loan product. I asked Caeli to come on today and just have a conversation with me about what is an adjustable rate mortgage today, how does it work, and what are the real risks. Hey, Caeli, what do you think?
Caeli Ridge: Hey, Leah. Thanks for having me. I’m having the same conversations that you guys are having, and I think that what’s missing is the education of it. For those of you that end up hearing this, I want to start by saying that this is empirical data. This is not opinion-based stuff. Well, I may throw in some of my own opinions as well, but I’ll make sure to preface that. I do think that largely investors are uninformed about the 30-year fixed and the adjust rate mortgages. We’ll start with, what is an adjustable? How does it work?
An ARM, adjustable-rate mortgage, is a component of two different numbers. You have an index and a margin. The index is variable, and there’s dozens of indices out there. The fed fund is an indices. Prime rate is an indices. There’s lots and lots of of index out there to choose from.
Then you’ve got the margin. The margin is fixed. That number for however long you keep that loan can never ever change. The two of those numbers added together is a fully indexed interest rate, and that’s how the initial rate for whatever term you’ve chosen. An ARM can be a 6-month ARM, a 1-year ARM, a 3-year, 5-year, 7-year, 10-year. There’s a whole variety of duration where the interest rate is fixed for that period of time before the rate can start adjusting based on predetermined rate caps.
Now, this gets a little bit technical, so I’m going to just abbreviate a little bit, and we’ll touch on whatever you think would be helpful. Let’s say for example, you start with an interest rate of 6 and a half percent on an adjustable rate 5-year mortgage. At the end of 5 years, the way in which that rate will adjust is dependent upon what the rate caps were when you originated the loan. The rate caps it can vary a little bit, but let’s just take a standard 225. There’s three numbers there, a 2, a 2, and a 5.
The first number represents how much the interest rate could adjust or increase in the very first rate adjustments. The second rate indicates how much the rate can increase with each subsequent rate adjustment if you let it just adjust, keep adjusting. Then the last number 5 is the life cap. Let’s just run through that math really quickly.
Again, if you started at 6 and a half percent, and at the end of 5 years, the index was up a full two percentage points to where that addition of the index and the margin would take your 6 and a half to 8 and a half, that is the max it could go. If the index was up 3% over where you started, it couldn’t go to 9 and a half. It could only go to that 8 and a half. That would be the cap in the first rate adjustment.
The second 2 is each subsequent rate adjustment. Now it’s going to be important to understand what your loan product is. Is it a 5/1 ARM? That 5-year fixed with the 1 after, it means that it can adjust one time per year. If the loan with the 5/6 ARM, that means that it’s fixed for 5 years, but then the rate can adjust every 6 months after the first 5 years. Make sure that if you get into an ARM, you understand the differences between how many times the rate can adjust after the fixed period, how many times in the 12-month period afterwards.
Leah: When you start one of these loans, do you know what the life cap is before you close on the loan?
Caeli: Yes, absolutely.
Leah: Okay, so you have a ceiling. You know the worst case scenario going into it.
Caeli: Absolutely. Each rate, so 2% the first max, 2% is the next subsequent max, cannot exceed in any given time more than additional 2%, but then the life cap is 5. If we started at 6 and a half, we know that 11 and a half is the absolute maximum. That rate could ever go for 30 years. You could keep this loan for 30 years. This is not a balloon feature loan that says that the note is due at the end of five years or whatever it is. We can just simply adjust. That’s the components or the mechanics of an adjustable-rate mortgage.
Why don’t I jump into, Leah, with your permission, just some of the statistical background in ARMs. As I’m doing that I want to actually take a step back in time and start from the pre-’08-’09, before the housing and lending debacle. Adjustable-rate mortgages were mainstream. In fact, I would say 98%, 99% of the mortgages that we would close for investors were on adjustable-rate mortgages, because then we were not on what’s called an inverted yield, so 2008-2009, that meltdown, created a scenario where adjustable-rate mortgages with an inverted yield means that a 30-year fixed rate price is lower than an adjustable-rate mortgage.
For the past 12 plus years, that’s where we’ve been, a 30-year fixed lower interest rate than an ARM. Why would you ever lock in an adjustable-rate mortgage if you can get a 30-year fixed at a lower rate? You wouldn’t ever. That inverted yield is starting. The tide is starting to turn. The reason for that is that obviously this year the feds have been rather aggressive with their rate hikes.
We’re starting to see that that movement, so that the adjustables are pricing lower. Now I think that we’re going to see a bigger margin there between an ARM and a fixed, where there’s more benefits for the ARM. Right now, I would say maybe at half a point, you’ll find that the ARM is better than a fixed, maybe three quarters of a percentage point. Ideally, you want them to be a half, three quarters of point, maybe more, lower than a 30-year fixed. That’s where we’re heading.
That’s why 30-year fixed have been the only loan to consider for the last 12 plus years. I want to just give you guys the statistical data. There’s a lot of emotion that goes into interest rate, and there’s bad information out there, and we get fixated on the sound bites, in the media and what they’re saying. The reality is if you take a 30-year fixed mortgage and you were to get a statistic that says how many people start with that 30-year fixed and make 360 payments later, they start here and they pay it off in 30 years, it’s less than 1%. It’s probably less than a half a percent, the percentage of people that actually do that. Very, very, very, very rare. Now, the shelf life of a 30-year fixed mortgage for a primary residence where you’re going to live is about seven years. We know that an investment property is probably two-ish years younger than that.
The average shelf life for investment property loan is about five years. Knowing that if we can get the lower rate on the ARM, which is what we’re seeing now, there really isn’t an incentive to take that higher 30-year fixed rate when we know that at the end of five years or two years or three years, whatever it may be, that you’re going to be refinancing one to maybe pull cash out harvest equity, rates are going to be lower. When rates go up, do they stay up?
Leah: Not usually.
Caeli: When they go down, they don’t stay down either, unfortunately. We know that we’re on the high. I think they’re going to continue to go up a little bit more over the next couple of months. I think it’s going to be a much more modest pace in which they go up, but I think we’re going to see a little bit higher in the interest rate category, but they’re going to come back down. As sure as death and taxes, rates are going to come back down.
The overwhelming majority says that in the next two to three years there’s going to be another refinance loan. Keep that in mind. If we know that five, six years, whatever it’s going to be we’re going to be refinancing that loan. That’s the first thing. The second thing, a lot of people I’m a fan of the interest-only loan too in addition to an ARM for these reasons.
The interest only side of this I think is beneficial because especially right now with higher interest rates and some of the loss of cash flow, I think we’re able to take advantage of the lower payment. That interest only affords us get a little bit more cash flow back.
All the while, if you look at an amortization table, you’re going to notice that the first 10 years of any 30-year fixed mortgage, 98%, 99% of your payment is going towards the interest. You don’t even start paying principal until the back end of that loan. For those reasons, I really think that investors should be doing the math, right? That’s the first and foremost, but ARMs have a place, and they will continue to be more mainstream than they’ve been for the last 10 plus years for reasons I’ve described.
Leah: Like I said, we’re all in agreement here at RealWealth. We think that this is the strategy that people should probably be imploring. Is there any downside? Are the fees higher with adjustable rate or interest only? No, they’re pre-comparable.
Caeli: There’s no fee difference. The only thing I would tell them is that if they are absolutely positive they’re going to keep that loan for longer than five or seven or whatever the ARM that they’re considering. Fine, take your 30-year fixed, but what are you giving up versus what are you gaining? Chances are you will be refinancing.
Leah: I suppose I could see the argument for someone who maybe knew they were going to have a change in employment or they were going to retire or something where it would be more difficult for them to qualify for a loan in the 5-year, 10-year horizon, that then maybe they would choose to suck up the lower cash flow for the first couple of years, get it on a nice 30-year fixed. If you’re someone who knows with reasonable certainty you’ll be able to get a loan in the future, which you would probably say, there’s always a loan you can get in the future.
Caeli: I was going to say that. I’m glad you did. There’s always a loan.
Leah: How do we convince people that this is not the ARM loans of the past? Everybody just has PTSD. I feel like from what happened before. How are those ARMs different back then?
Caeli: Well, when we look back, and we look at those neg ARM loans or the no income, no asset loans, or the 115% LTV loans, so those “bad boy” loans. I think that that ties into. That’s a good point. I think that ties into people’s emotional connection to this or the mentality that they have about ARMs. They think just a standard adjustable-rate mortgage is the devil because of those sound bites. They don’t realize that there’s a vast difference between a straight adjustable-rate mortgage and the ones I just described, where investors were getting a 100% LTV, no down payment whatsoever, no income documentation, and no asset documentation.
There were things called neg ARM loans where you can actually pay a lower payment than principal or interest. We didn’t do any of those. I think that that’s why ARMs were lumped into that because most of those are adjustable-rate mortgages, but they have different components. Hybrid features to it. I would say that in terms of education, guys, just do the math. The math will never lie to you. If you look at a 30-year fixed against a five-year ARM, let’s just use five years as our example, what is the monthly payment difference? Whether it’s principal interest to principal interest or principal and interest to interest only, what is that monthly difference? Then you should be able to tell pretty clearly what your options are and which makes the most sense.
Leah: Do you have a percentage that you like to see generally a difference between the two that would make one more compelling over the other?
Caeli: I would say half a point is where I want the ARM to be in benefit or the interest reduction to the fixed.
Leah: Meaning you want the interest rate of the ARM product to be half a percent lower than what the 30-year rate would be?
Caeli: Yes, to consider. If it’s less than that, well, it’s largely dependent too on the loan size. I think we’ve talked about this before. On a smaller loan size, a quarter of a percentage point, let’s say that the ARM is 6 and a half and the fixed is 6.75 on a hundred grand, take the fixed. It’s $12. It’s non-inconsequential. I would take the fixed in that example.
Leah: I was looking at some performance the other day, and the difference of the ARM loan saved you 89, or I think it was close to right around $90 a month. It was a cheap house too, so like the cash flow, it increased by over 50% to go with the ARM loan. In that case, it’s a no-brainer. It took your return I think from 6 and a half percent cash-on-cash return to a 9% cash-on-cash return simply by selecting this loan over the other.
Caeli: That’s the math. They have to be doing the math. Don’t make assumptions based on psychological or emotional assumptions.
Leah: It’s hard though. A lot of messages out there conflicting, and so it’s good to hear it straight from you. Caeli, if somebody wants to get in contact with you to learn more about your services, about the loans you offer, or if they have questions about adjustable-rate mortgages, how can they get in contact with you?
Caeli: There’s several ways. They can check us out on our website, ridgelendinggroup.com. They can call us toll-free at 855-74-RIDGE, email [email protected]. Any of those will get directly to us, and we’ll be on standby.
Leah: All right. Good deal. Thanks for joining me.
Caeli: Hey, you bet.
Leah: See you.
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