Play the Long Game: Avoid Adjustable Rate Mortgages

Most areas of the real estate market have seen substantial price increases since 2020. These increases, along with increased interest rates, have made it hard to make deals pencil out and show cashflow. Even though my company MC Companies looks for deals every day, the ones where there is potential for cashflow are few and far in between.

Because it is hard to find cash flowing deals, this is the point in the cycle when people start trying to get creative to make cashflow work. I love the creativity and I do this in my own company. Some people look at adding additional dwelling units or upgrading units to provide more cashflow. Even looking at buildings that are managed poorly or are undervaluing their rents are hidden opportunities to make a deal work.

However, there is one strategy I am strongly against that many gurus are recommending, and I want to address this “strategy” and the issues I have with it in today’s environment. Adjustable rate mortgages or ARMS, are a tool that some are recommending people use in order to make the cashflow work. For those that don’t know how an ARM works, it essentially is a mortgage rate that fluctuates and is not fixed. Depending on the terms, the ARM will determine how often it can adjust its rate, but no matter what, it is not a fixed rate. People go for these mortgages because the initial rate is lower.

This is a big bet to take on the Federal Reserve. If you take out an ARM, you essentially are betting the FED will lower rates significantly in the next couple of years. However, if they don’t, then you will be cruising for a much higher rate than if you locked in to fixed rate debt. Ross and I have locked in most of our properties, and the few we have left to refinance we are currently working on as we speak.

A few other things to consider about adjustable rate mortgages is even though they go up, they don’t necessarily go down when rates start to fall. Normally they hold steady or continue to increase. This puts people in a bind like it did in 2008, when the downpayment has increased so significantly, the borrower cannot even make their payment.

Now you may be thinking if that were to happen, you can always refinance into fixed debt, but the question is, can you? In 2008, property values went down. Ross and I owed more to the bank than what the properties were worth. What saved us was the cashflow. If the property you purchased no longer is worth what you bought it for, you cannot refinance. If the payment becomes too high for you to make each month, now you are in a dilemma. You can’t refinance, you can’t sell, so you either make the payments or walk away from the property. That is not a position you want to put yourself in.

In times of high inflation and a very aggressive FED, you only want to be in fixed debt. Sure, the FED may lower rates in the next couple of years and real estate values may remain strong. If this is the case, I will still hold my position, because as an experienced investor I know these are not gambles you want to take. Play the long game. Play for cashflow and use fixed debt in times like these where rates are going up and values are not. Don’t try and make deals work by taking risks; find deals that work fundamentally with the current fixed rate environment. Remember, slow and steady always wins the race.

About The Author

Ken McElroy is the co-partner of MC Companies in Scottsdale, Ariz. He is the author of the best-selling books, The ABC's of Real Estate Investing, The Advanced Guide to Real Estate Investing, and The ABC's of Property Management. McElroy is also a contributor for The Real Book of Real Estate by Robert Kioysaki, and The Midas Touch by Donald Trump and Robert Kiyosaki. McElroy's fourth book, The Sleeping Giant, is dedicated to the new class of entrepreneurs who are emerging in today's economy. For editorial consideration please contact editor@jetsetmag(dot)com.

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