Option ARMs: 'The Sky is Falling-The Sky Is Falling' So Say The Chicken Littles Of The World

Jan 12, 2021

Every investment vehicle and financial program under the sun has some sort of risk attached to it. Whether it is stocks, bonds, stock options (deep in the money/out of the money) puts,rental arbitrage airbnb, stock shorting, derivatives, mergers, Real Estate Investment Trusts, etc. The key is managing the risks within suitable parameters while superimposing an investment template and guidelines over the investment.

Many have used the Option Adjustable Rate Mortgage for consumer home purchases and some are in deep do-do for never understanding exactly what the downside held for them. Many wealthy people have used the Option ARM in combination with financial planning, as they knew exactly what to do with the payment difference between the fully indexed payment and the option payment. They put it to work to more than offset any negative amortization and have benefited. A well-known lender proponent of this vehicle structures the deal with an 80% or lower LTV (Loan To Value) and offers a biweekly payment schedule. This allows the borrower to pay the loan off in 21 to 22 years by making one extra payment per year thereby shortening the term and saving 8 to 9 years of payments. This can make for tremendous savings while working within the program guidelines. The problems started when the Option ARM became morphed by new players in the game by allowing Piggy-Back Second mortgages behind the potentially negative ARM thereby putting more pressure on the borrower to keep up with the adjustments during the current mortgage upswing. Typically the monthly payment has a 7.5% built in escalator per year for the first five years with an additional limitation of the amount of negative amortization (original mortgage amount goes up) 115% of the original loan amount.

So do we through the baby out with the bath water, or is there a way to make this program work?

Let's then look at a four-unit residential investor property acquisition using an OPTION ARM mortgage vehicle. This is a scenario and discussion of buying property in a softer market as is found in many areas of the country. If the goal in any investments is to make something in the range of 10% plus or minus in other investments then how would this four unit stack up. First of all if you are a professional property manager, great. If not, spend a lot of time to locate and interview a licensed professional property manager perhaps with a Certified Property Manager Realtor designation. Proper management is a must. A street smart Realtor who is not afraid to make lots of low offers is another. Like stocks, a margin account can get you about 50% leverage. Likewise real estate has that and more. Our goal then would be to buy an undervalued property with seller help on costs. The property will be structurally sound with a good roof but may be tired looking and dated with tenants paying less rent than the market. After negotiating a stellar price and term deal the financing will need to allow us CASH FLOW while we tune up the exterior and interior including updated baths and kitchens, carpet and new decorating. The existing tenants will be given the opportunity to stay and pay the higher rents or move and bring in new rental customers who can appreciate the amenities of the new digs.