Specialty Mortgages for the Texas Coast
As a strategy for investors, renovators, and developers often called “home flippers” who do not intend to keep the home to maximize ROI.
- Interest-Only Mortgages (I-O)
- Adjustable-Rate Mortgages (ARM) with the option to make a minimum payment
Owning homes is part of the American dream. But high home prices may make this seem out of reach. To make monthly mortgage payments more affordable, many lenders offer home loans that allow you to:
- pay only the interest on the loan during the first few years of the loan term or
- make only a specified minimum payment that could be less than the monthly interest on the loan.
Whether you are buying a house or refinancing your mortgage, this information can help you decide if an interest-only mortgage payment (an I-O mortgage)—or an adjustable-rate mortgage (ARM) with the option to make a minimum payment (a payment-option ARM)—is right for you.
Lenders have a variety of names for these loans, but keep in mind that with I-O mortgages and payment-option ARMs, you could face payment shock. Your payments may go up a lot— as much as double or triple—after the interest-only period or when the payments adjust.
In addition, with payment-option ARMs you could face negative amortization. Your payments may not cover all the interest owed. The unpaid interest is added to your mortgage balance so that you owe more on your mortgage than you originally borrowed.
Be sure you understand the loan terms and the risks you face. And be realistic about whether you can handle future payment increases. If you’re not comfortable with these risks, ask about another loan product
What is an I-O mortgage payment?
- Traditional mortgages require that each month you pay back some of the money you borrowed (the principal) plus the interest on that money. The principal you owe on your mortgage decreases over the term of the loan. In contrast, an I-O payment plan allows you to pay only the interest for a specified number of years. After that, you must repay both the principal and the interest.
- Most mortgages that offer an I-O payment plan have adjustable interest rates, which means that the interest rate and monthly payment will change over the term of the loan. The changes may be as often as once a month or as seldom as every 3 to 5 years, depending on the terms of your loan. For example, a 5/1 ARM has a fixed interest rate for the first 5 years; after that, the rate can change once a year (the “1” in 5/1) during the rest of the loan.
- The I-O payment period is typically between 3 and 10 years. After that, your monthly payment will increase—even if interest rates stay the same—because you must pay back the principal as well as the interest. For example, if you take out a 30-year mortgage loan with a 5-year I-O payment period, you can pay only interest for 5 years and then both principal and interest over the next 25 years. Because you begin to pay back the principal, your payments increase after year 5.
What is a payment-option ARM?
- A payment-option ARM is an adjustable-rate mortgage that allows you to choose among several payment options each month. The options typically include
- a traditional payment of principal and interest (which reduces the amount you owe on your mortgage). These payments may be based on a set loan term, such as a 15-, 30-, or 40- year payment schedule.
an interest-only payment (which does not change the amount you owe on your mortgage).
a minimum (or limited) payment (which may be less than the amount of interest due that month and may not pay down any principal). If you choose this option, the amount of any interest you do not pay will be added to the principal of the loan, increasing the amount you owe and increasing the interest you will pay.
- Interest rates. The interest rate on a payment-option ARM is typically exceptionally low for the first 1 to 3 months (2%, for example). After that, the rate usually rises to a rate closer to that of other mortgage loans. Your monthly payments during the first year are based on the initial low rate, meaning that if you only make the minimum payment, it may not cover the interest due. The unpaid interest is added to the amount you owe on the mortgage, resulting in a higher balance. This is known as negative amortization. Also, as interest rates go up, your payments are likely to go up.
- Payment changes. Many payment-option ARMs limit, or cap, the amount the monthly minimum payment may increase from year to year. For example, if your loan has a payment cap of 7.5%, your monthly payment won’t increase more than 7.5% from one year to the next (for example, from $1,000 to $1,075), even if interest rates rise more than 7.5%. Any interest you don’t pay because of the payment cap will be added to the balance of your loan.
- Payment-option ARMs have a built-in recalculation period, usually every 5 years. At this point, your payment will be recalculated (lenders use the term recast) based on the remaining term of the loan. If you have a 30-year loan and you are at the end of year 5, your payment will be recalculated for the remaining 25 years. The payment cap does not apply to this adjustment. If your loan balance has increased, or if interest rates have risen faster than your payments, your payments could go up a lot.
Ending the option payments. Lenders end the option payments if the amount of principal you owe grows beyond a set limit, say 110% or 125% of your original mortgage amount. For example, suppose you made minimum payments on your $180,000 mortgage and had negative amortization. If the balance grew to $225,000 (125% of $180,000), the option payments would end. Your loan would be recalculated, and you would pay back principal and interest based on the remaining term of your loan.
How To Determine an Income Property’s Value Using Capitalization Rate
1. Determine the net operating income of the subject property the client is considering purchasing. If it’s an apartment complex, determine the net rental income after expenses.
Example: A six-unit apartment project yielding $30,000 net profit from rentals.
2. From recent comparable sold properties, determine the capitalization rate.
3. Divide the net operating income by the capitalization rate to get the current property value result.
Example: Assume a capitalization rate of 11%.
$30,000 / .11 = $272,727 current value of the property.
How To Calculate Capitalization Rate for Real Estate
By using other properties’ operating income and recent sold prices, the capitalization rate is determined and then applied to the property in question to determine current value based on income.
1. Get the recent sold price of an income property, such as an apartment complex.
Example: Six-unit apartment project sold for $300,000
2. For that same apartment project, determine the net operating income, or the net rentals realized by the owners.
Example: The rental income after expenses (net) is $24,000
3. Divide the net operating income by the sale price to get cap rate.
Example: $24,000 / $300,000 = .08 or 8% (The Capitalization Rate)
An Example Rental Property Cash Flow Calculation
This is a simple cash flow calculation to illustrate the potential of real estate as an investment. Critical to this, as with most investments, is an intelligent and well-researched purchase on the front end. We’ll assume for our example that this buyer did their research and made a good buy on our fourplex.
Here are the purchase and rental particulars:
1. The purchase price of the fourplex is $325,000.
2. The buyer places 20% down, or $65,000, financing $260,000.
3. A 30-year loan is at 6.5%, with Principle/Interest payment of $ 1643 per month.
4. Taxes and insurance at purchase are $3600/year, for total payment of $1943 per month.
The buyer did their research and sees a steady rental demand for these units, all of which stay occupied most of the time. However, to be prudent in their calculations, a 6% vacancy and non-payment risk will be calculated to anticipate real cash flow. The units are all identical and rent for $900 per month each.
1. Gross rental income is $900 X 4 X 12 months, or $43,200 per year.
2. Payments are $1943 X 12 = $23,316 per year.
3. The previous owner’s repair expense has averaged $1700 per year.
4. Vacancy and credit loss is estimated at 6% of rents or $2592 per year.
5. Owner spends about $400 each year in miscellaneous and advertising costs and manages the property on their own.
Calculation to the profits:
• Rent income – Vacancy Loss – Payments – Expenses = Cash Flow
• $43,200 – $2592 – $23,316 – $2100 = $15,192 / 12 = $1266 per month in positive cash flow.
Analyzing your return as “cash on cash invested”, you would divide your actual cash investment of $65,000 down into the annual return of cash, or $15,192. This is a yield of 23% of your cash invested.