Latest / Cash Flow for Life / Chapter 6: Understanding Mortgages
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- 00;00;00;04 - 00;00;26;29 Chapter six Understanding Mortgages. We have learned about leverage and why we need it. We know that using other people's money will allow us to expand our property portfolios and increase our cash flow. We also know that we can enjoy more appreciation and control more assets than our cash alone could have ever purchased. It's time to get into some of the mechanics of financing property purchases. 00;00;27;02 - 00;00;50;17 With a primer on mortgages. Unless you've been a mortgage broker in the past, don't skip this chapter simply because it's not exciting enough for you. Learning about mortgages will provide some of the most exciting moments in your rental property investing activities. When you find the perfect property that passes your due diligence and commands top rents, your next step is to buy it. 00;00;50;19 - 00;01;15;03 Finding out that you can't get the right mortgage to make the cash flow numbers work can be a major disappointment. However, using your knowledge of mortgages to get the right loan that creates cash flow above your minimum requirement can be really exciting. When we say love the numbers, not the house. The mortgage rate and mortgage payment are two of the most important numbers to love in real estate. 00;01;15;09 - 00;01;40;10 Leverage is normally in the form of a mortgage on the property. The property becomes the security of the money loaned and the borrower must repay. Per the terms of the loan, or risk losing the property in foreclosure as rental property. Real estate investors using leverage will be applying for mortgages that fit the numbers we need to make our deals and rental income cash flow work. 00;01;40;12 - 00;02;03;16 At the time of writing, the most popular mortgage in the United States is the 30 year fixed rate mortgage and a five year fixed rate in Canada. However, there are a number of mortgage structures and combinations available to borrows in both Canada and the US. The type and duration of mortgage selected will depend on a number of factors, including the following. 00;02;03;18 - 00;02;34;09 How long the property is to be held. The desired interest rate to make the numbers work. The balance between interest rate and risk. The borrower's credit profile. The type of property in rental property investment. You should always think about the numbers. Love the numbers, not the house. One of the most important numbers is the mortgage rate. Because it is a major part of your cost and cash flow. 00;02;34;11 - 00;02;58;23 The type of mortgage can influence this cash flow enough to stop a deal dead in its tracks. On the other hand, the right mortgage can make a deal happen by bringing cash flow in line with your requirements. When purchasing that first property back in college, a mortgage was necessary, but we didn't have a clue about the different choices that may have been available to us in our financial condition. 00;02;58;25 - 00;03;22;14 Just getting anything was exciting, so we took whatever was offered. We've learned since then that the type of mortgage can make or break the deal, or it can make a much better cash flow generator. Let's look at a couple common US mortgage types. Note that these mortgages are generally specific to the US market. 30 year fixed rate mortgage. 00;03;22;17 - 00;03;46;08 Fixed rate means that the mortgage interest rate is fixed for the entire duration of the loan. If it starts at 6% 20 years later, it's still 6%. The 30 year fixed rate loan is particularly popular with residential owner occupants, because they want the security of knowing that their principal and interest payments will not change for the life of the loan. 00;03;46;10 - 00;04;14;18 However, the secure feeling due to a never changing interest rate comes with a price. Loans of shorter duration can be had at lower interest rates. Longer duration. Higher interest rates. The shorter the time frame of the loan, the lower the interest rate. And this makes sense because lenders want the best return for their investment. There are willing to trade some of that return for the security of the shorter loan term. 00;04;14;21 - 00;04;35;29 15 years of risk is half of the risk they take on when loaning money for 30 years. Remember from our leverage chapter that some investors are more focused on long term returns than on a lower rate, so they are happy to loan money for 30 years, or to be able to project their income stream for that longer period of time. 00;04;36;01 - 00;05;00;17 Multiple surveys have been done, and they often come up with different estimates of how long the average homeowner keeps a home. However, most of them show that the range to be between 5 and 8 years. That's far shorter than the 30 year mortgages that most homeowners took out as a real estate investor. You should have a plan for how long you want to hold on to your properties, including the rental properties. 00;05;00;19 - 00;05;20;01 The quick answer is for as long as the cash flow works. However, if appreciation is going well, at some point you may find it more advantageous to sell the home and roll your profits into another home or two. Or depending on your life situation, it may be the right time to sell a home for any sort of life experiences that are coming up for you. 00;05;20;03 - 00;05;48;24 Whatever your plan is at this moment, you may want to look at other loan types and durations. Then the staple 30 year fixed rate loan, 15 year fixed rate mortgage. The quick analysis of this loan is that it's for half the time of the 30 year mortgage. However, the major consideration for the real estate rental property investor is that while this loan will carry a lower interest rate, the shorter duration will make the payments higher. 00;05;48;26 - 00;06;13;22 A quick check at the time this was written showed that several national lenders, or quoting rates that provided a 5/8 point discount for 15 year fixed rate loan. In other words, you would save 0.875% if you board for 15 years instead of 30 years. However, the monthly payments would still be higher than they would at the higher rate the 30 year loan. 00;06;13;25 - 00;06;40;01 That's because you're paying off the entire loan over 15 years instead of over 30 years. For this reason, the 15 year loan is not favored by investors. While there may be a reason for using this type of loan, the higher payments make it much harder to reach monthly cash flow goals. Adjustable rate mortgages arms are a are as opposed to fixed rate mortgages. 00;06;40;05 - 00;07;03;29 Adjustable rate mortgages arms have temporary interest rates that will adjust at some point in the future. Be sure you understand how much they might change and how this adjustment will be determined. Investors with a very low risk tolerance may want to avoid arms, even though they will be forgoing some cash flow to do so. It's the price you pay for peace and convenience. 00;07;04;01 - 00;07;29;29 If you want a really detailed education arms, you can get it at the US Federal Reserve's website. However, you will find enough information here to make sound decisions and use arms wisely if you find them appropriate for your property. Funding needs. As far as understanding the most important things to be concerned about when using arms, you should know that monthly payments can change even if interest rates do not. 00;07;30;02 - 00;08;07;17 Payments can go up sometimes a lot. Payments can go down or not at all. The borrower may end up owing more than he or she borrowed. There could be payoff fees, comparing arms with each other and with fixed rate loans can be challenging because of the array of factors that go into their makeup. You need to know about indexes, the basis on which arms are adjusted, margins, discounts, rate caps, negative amortization payments, and recasting or recalculation of the loan. 00;08;07;19 - 00;08;40;04 Remember that arms are issued at lower rates than fixed rate loans, sometimes a lot lower. The most common arms are seven year, five year, and three year. While one year arms do exist, we'll focus on longer duration arms, which are more suitable for use by real estate investors. At the time this was written, national lenders according to the following discount for a 30 year loan, a seven year arm was -1.25% from the 30 year fixed loan. 00;08;40;07 - 00;09;01;09 A five year arm was -2.0% from the 30 year fixed loan, and a three year arm was -2.5% of the 30 year fixed loan. Now, these numbers are always changing. You've got to find out what's happening in the market today. And when you're buying a property a year from today, you're going to find out what's happening in the market a year from today. 00;09;01;11 - 00;09;21;23 These are just some examples of the difference in ratios from a three, five and seven year arm compared to the 30 year fixed loan. It's easy to see that there's a considerable contribution to cash flow with these discounts to a fixed rate loan. Of course, you should try to match up your anticipated holding period to the arm duration. 00;09;21;26 - 00;09;46;19 Or you could end up having to refinance at a rate that will negatively affect your cash flow. For example, if your plan is to buy a property, fix it up, rent it out and hold it for five years, and then exit through a sale at five years. Then you're probably going to want to start with looking at a five year arm, or any sort of five year loan, because you want to match up the loan duration with your strategy. 00;09;46;21 - 00;10;08;06 What about Dennis? Remember Dennis from our credit chapter? He had a very expensive mortgage due to his low credit score. Dennis may want to consider an arm for his loan. This will offset the increased rate from his low credit score. Reducing his eye interest rate by a couple of interest points would make a big difference in Dennis's payment. 00;10;08;08 - 00;10;32;05 The risk he takes on related to rates three years later can be offset by working on his credit score for that period. Bringing up his credit score can make it possible for him to refinance in three years, keeping his interest rate manageable. An arm for you. There may be valid reasons for taking out an arm, even when you plan to hold the home past the adjustment period. 00;10;32;08 - 00;11;01;12 One reason could be that you anticipate the ability to raise rental rates enough to compensate for the adjustment, using the five year rate discount. Let's see how this can help our cash flow on a home purchase for $150,000 with a $50,000 loan. The monthly payment savings is $115 per month over the five year period. We would realize an extra $6,900 in cash flow going with the arm. 00;11;01;15 - 00;11;15;29 Looking at it another way. If you want a cash flow of $500 per house, as we did in our college purchase, you'd be getting an extra 23% return if you used the five year arm. 00;11;16;01 - 00;11;49;28 How arms work adjustment period. Using our three arm examples, let's talk about adjustment periods. At the end of the period, it's typical for the arm to adjust. So our five year arm will adjust at the end of five years. The index. The interest rate of an arm is made up of two components the index and the margin. Generally, the index is a measure of interest rates, while the margin is an additional amount above the index that is added by the lender. 00;11;50;00 - 00;12;22;21 In most cases, if the index rate rises, so do the arm interest rate and loan payments. If the index rate goes down, some arms will take their rates down and others will not. Lenders base their arm rates on a number of indexes, with most common being the one year Constant Maturity Treasury Securities, or CMT. The Cost of Funds Index Coffee and the London Interbank Offered Rate LIBOR. 00;12;22;24 - 00;12;46;04 When you're considering an arm, make sure you know which index is being used. Take a look at the historical fluctuations of that index to see what could happen to your future rates. Margin. The margin refers to the points added to the index by the lender. Remember, this is a business and they have to make money. While margins can differ by lender. 00;12;46;10 - 00;13;15;12 Margins are usually constant for the life of the loan. The fully indexed rate is equal to the margin plus the index. For example. Index 4%. Plus margin 3%. The fully indexed rate 7%. If the index in this example were to rise 5%, the fully indexed rate would then be 8%. Returning to our discussion of credit scores and their importance. 00;13;15;15 - 00;13;41;08 We find that some lenders based their margin on your credit score. The better your credit score, the lower the margin they're willing to accept, because the lower the perceived risk for the lender. Interest rate caps. An interest rate cap is a limit on how much your rate can increase when the index increases. They come in two versions. One periodic adjustment cap. 00;13;41;10 - 00;14;13;02 After the first adjustment, this cap limits the amount. The interest rate can adjust up or down from one adjustment period to the next two lifetime cap. This cap limits the interest rate increase over the life of the loan. U.S. law requires that all arms have a lifetime cap. Payment caps. Many arms also have payment caps. These caps limit the amount the mortgage payment can go up even if interest rates rise. 00;14;13;04 - 00;14;39;12 It's not a free ride. However, if the payment cap reduces the increase that the index dictates, the balance is added to the end of the loan. Types of arms. Hybrid arm. Hybrid arms are often advertised as three over one, five, or 1 or 7 over one arms. They are a combination of a fixed rate period and an adjustable rate period. 00;14;39;14 - 00;15;07;21 The first number tells you how long the fixed interest rate period will be. The second number tells you how long the rate will be adjusted after the initial period. So a three one arm will go for three years at the initial rate and adjust every year after that. Interest only arms. This type of loan allows you to pay interest only, not principal, for a specified number of years, typically 3 to 10. 00;15;07;24 - 00;15;39;29 Your payments will start out low and then they will increase at the end of your interest only period. Payment option arms A payment option ARM allows you to choose among several payment options each month. These typically include the following a traditional payment of principal and interest, which reduces the amount you owe on the mortgage month over month. An interest only payment which pays the interest but does not reduce the principal amount owed on the mortgage. 00;15;40;01 - 00;16;09;08 A minimum or limited payment, which allows you to pay a set amount each month, but may not be enough to cover the interest, causing the loan balance to increase. Payment option arms are not normally of interest to some real estate investors, but now you know something about them. However, sometimes one of the arm options can be just right for the type of loan and the rental property the investor needs and their cash flow requirements at that time. 00;16;09;11 - 00;16;34;04 Knowing how they work and what to look for will help you know when an arm is appropriate to increase cash flow and improve your bottom line. The strong arm approach. We love arms because they increase our cash flow early in the ownership period. However, when we're running the numbers, we're evaluating the home based on the fixed rate that may result at the end of the arms initial fixed period. 00;16;34;06 - 00;16;55;07 In other words, if we decide to purchase a home with a five year arm to get a really great interest rate, we'll still run the numbers based on what the rate is likely to be. After the initial five year period. This means that we'll always have a profitable investment generating the cash flow that we want, but we'll be getting bonus cash flow for the first five years. 00;16;55;09 - 00;17;20;20 I'd rather have bonus than a bad surprise. Home equity line of credit. Key luck. If you own a home, you can set up a line of credit to access your equity. Many investors have used this type of loan to buy their first investment property, using simply equity from their primary residence. This loan can also be used to access funds for improvements to rental properties. 00;17;20;23 - 00;17;46;29 Significant equity can be tapped with this predetermined line of credit simply by writing a check or making a transfer. You can use the credit line or not as you need it. Paying back the loan builds back the line of credit to be used again and again as needed. This is often called revolving or revolving line of credit or revolving hillock combo or piggyback loans. 00;17;47;01 - 00;18;14;28 Piggybacking one loan on top of another is the concept with these loans. A second mortgage on top of a first can allow the borrower to get into a property with a smaller down payment, and with no private mortgage insurance. When 20% equity is required to avoid paying PMI premiums, the combo loan can help by taking out a second mortgage to cover the difference between the available down payment and the 20% requirement. 00;18;14;29 - 00;18;45;28 You could avoid PMI. Love the numbers. Understanding mortgages and how they work is quite important in building a successful real estate investment business, and lifetime cash flow for yourself. Selecting the right mortgage for your purchase is critical to cash flow considerations and exit strategies. Our approach. An old axiom of investing is that you should never enter into an investment unless you know how and when you're going to get out of it. 00;18;46;00 - 00;19;09;26 While you may not know precisely how long you plan to own a rental home, some idea of the time period will allow you to select from numerous mortgage options, even if the time period is 30, 40, or 50 years plus. We are always working with you to build lifetime cash flow and generational ownership. Buying property to keep and rent out for cash flow is our approach. 00;19;09;28 - 00;19;39;09 Owning cash generating properties provides a valuable estate to be passed on to your heirs or your children or whoever. So your overall plan is to buy and hold property for an extended period of time forever. Of course, situations change and economic or investment considerations could result in the desire or need to sell a property at any time. Learning about selling properties and maximizing your ROI is all a part of this process. 00;19;39;12 - 00;20;05;26 The long term ownership is the primary goal. When the numbers are right. Cash flows to you. Always make the selection of a mortgage a high priority in your rental property. Investing. Action steps. If you have a mortgage on your personal residence, get it out and take a look. Read the terms and conditions and be sure you understand the interest in how it's paid. 00;20;05;29 - 00;20;33;20 Spend some time going through mortgage broker advertisements and materials related to arms. Learn the differences in similarities among the different arms available. Compare the various arms with fixed rate loans using actual numbers for a sample property purchase. The more you practice, the better you'll get. What's next? In the next chapter, we take you an important step closer to actually getting started purchasing a property. 00;20;33;22 - 00;20;43;11 We help you begin the selection of your investing team members. It's a team activity, so you'll want to build an effective team to help create your lifetime cash flow.