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Don’t Be Afraid Of What You Don’t Understand

understanding rental property loans

ARM’s are not really that scary

I’m going to go out on a limb here and say that everyone is good at something. Maybe it’s a skill picked up over time or with experience. Maybe we learned it in school. Maybe our parents taught us. Brain surgeons are good at neurology. Crackheads are good at finding ways to obtain crack. We all have our strengths and often don’t stray outside of the comfort zone. Today, I’ll tell you a story of how our comfort zone almost cost us thousands of dollars, all because we were afraid of what we didn’t understand.

Fourplex Drama

I won’t say we are skilled real estate investors, but with two properties under our belts, we felt OK with branching into a multi-family property. Everything was going almost too smoothly with the process.

Things I thought might be a problem were non-issues including repairs we wanted the seller to make,  our credit card churning history and my change in employment status. What did become a huge issue was something far beyond our control. There were no comps for the type of property we were trying to buy.

What Does No Comps Mean?

In order to get a mortgage, you have to have the property appraised to make sure it’s value is at or above your loan amount. For that to be possible, recent sale prices of similar type properties must be close in price to your purchase price.

Our property includes a very nice house with another two unit building, all on a nice street in the best part of town. There were only two other four unit dwellings sold in the past decade, and both of those were section 8 type tenements. The highest priced one was sold for $60,000 less than our four plex. To say we were comparing apples to oranges would be an understatement.

The appraiser used a triplex and and a couple of duplexes that were more in line with our property, but the bank would not accept those as adequate comps and refused to fund the loan. Yes, we did check with different lenders. No. End of discussion.

The ARM solution

Our lender came back with a 7/1 adjustable rate mortgage option, and my knee jerk reaction was no way. All I knew about ARM’s was that those were how so many people lost their homes during the recession. Every property loan we’ve ever had has been fixed rate for the length of the loan.

We were about to pull the plug, which would have meant our $2500 in earnest money, $600 inspection fee, and whatever the appraisal cost was would be down the drain. Plus, we lose out on this one of a kind opportunity because, obviously, there are no other properties like this in our area.

Slow Down And Think

Instead of walking away, I asked the lender to give me a day to study ARM’s. What I found was that they can be a great way to finance rental property, and the fear of the rate going up into double digit interest was unfounded. If you are choosing an ARM because you have poor credit or can’t afford the fixed rate, that’s a poor choice. If you are looking for lower interest rates, flexibility and have the income to support the max payment if it comes to that, then they can be great loans.

All in all, unless we have Armageddon, it will save us money over the life of this loan as the interest rate is lower than a 30 year fixed. I won’t get into all the pros and cons of ARM’s in this post, but there is lots of credible information out there if you take the time to look.

Knee Jerk is Usually Not the Answer

How many of us are tainted with stories from the news or from friends and family who went through a bad time and have generalized that to avoid all similar scenarios.

I can’t tell you how many people I know who will not go near the stock market because Uncle Joe lost his shirt in 2008. Uncle Joe was probably too heavily invested in stocks and pulled out at the bottom of the market.

The stock market is not evil, and people are losing money every day they keep all their retirement in money market funds. Anyone who takes time to do the research could tell you this.

It’s Hard To Step Outside The Comfort Zone

I know it’s much less risky to keep all our money in a nice, safe savings account, but if that makes me poor in retirement, is that the life I want?

Everything I can think of that brings me joy also comes with some risk. The best I can do is educate myself, try to  minimize the risk, and not live in fear. It is hard to step outside your comfort zone, but if we never did that, I’d still be working a million hours a week in the office and feeling miserable. We’d have no rental properties, and we’d probably still be in debt because it takes an effort to get out of the comfortable pattern of credit and overspending.

How Can You Know?

There is also risk of not being cautious enough. You certainly don’t want to jump into an investment because one person told you it was a good idea. While you can never be 100% sure of much, there are steps you can take when faced with the unknown.

1)Make a list of pros and cons

If you look at the worst thing that could happen AND you can live with it, then it’s probably worth moving forward. In our case, the highest payment our ARM could reset to in 7 years was still within our comfort zone.

2)Research from credible sources

I didn’t want to listen to the lender or real estate agent when deciding about a loan. I trust both of them to do their jobs well, but ultimately,they want to close the deal. Find a person who has been in your situation or look online for someone who can explain the pros and cons without any bias.

3)Always have a backup plan

Our backup plan for this property if we decide not to keep the ARM past 7 years would be to refinance after paying down principal. We could also put it up for sale if we had to. Because the purchase price is below market value, regardless of what the comps say, I’m confident we can sell it after we establish a strong history of rentals. That would not be my first choice, but it would be a good fall back if we need one.

If you decide to invest in something you aren’t 100% knowledgeable about, then make sure to diversify other investments and be sure to have an adequate emergency fund just in case.

4)Don’t procrastinate

While it is important to do your homework, that doesn’t mean you have to know every intricacy of the stock market before you invest. I don’t know everything in the world about rental property, but I know enough to move forward. If I waited until I was an expert, I probably would miss out on tons of great opportunities.

Are there things you stay away from because you don’t fully understand how they work? Do you prefer to stay comfortable or step outside the norm?

 

Image: Freedigitalphotos.net/Habbick

 

 

About Kim Parr

Kim Parr is a private practice optometrist, freelance writer, and personal financial blogger. You can follow her journey to 20/20 financial vision at Eyes on the Dollar.

22 comments

  1. Very interesting. Someday I have high hopes of owning rental properties and these are really great tips to keep in mind. I have heard horror stories about this type of business, but I also will choose to have my own experiences and deal with it as it comes.

  2. I am still a little nervous about the idea of becoming a property owner. Lately I have begun to read more about it and ask questions. With more knowledge, I will feel more comfortable if we choose to go down that path. Fear and lack of info often can lead to unwise decisions. Glad that the ARM loan was an option for you.

  3. Nice job in walking through the process Kim. I talked to many of those investors and it just didn’t make sense for them to walk away and most often it led back to them not educating themselves. That said, before we started the business I was much more risk-averse. Now, I’m more willing to take it on if it makes sense to do so.

  4. For me it’s less about comfort zone and more about avoiding hassle and headaches. When I was buying my used car earlier this year, I wanted to go through a dealer because it seemed a lot more cut and dry and easier, but my friend convinced me to look outside of that at private sellers. He walked me through a lot of things and glad I did because I found a great deal on a used car.

  5. Good post and it speaks so many truths about people fearing so many aspects of finances. The arm is risky, but if the time comes when rates rise, the increase will be capped at 1-2% per year on average. Its not like the rate is 3% and then tomorrow it will be 7%. (That rarely happens unless your dealing with credit card companies)

    • That is exactly what I did not understand and now I do. You can determine your max payment even many years down the road and it’s not that bad. I guess if you were barely scraping by, and extra $200 might kill you, but if you buy under your max price, it should not be a huge deal.

  6. Nice work not walking away Kim. I used to be in mortgages and ARMs were popular. They can be great ways to get into a home if a traditional loan won’t cut it. While many people lost their shirts with ARMs, it was due to them not being able to afford the property to begin with. I know many people who leverage them appropriately.

  7. Good thing you slowed down and did some research for yourself. That’s great advice for all of us. I typically listen to my Dad’s advice, but sometimes I’ve been glad that I have done my own research too. Most of the time I find that he’s right, but once in a while I make a different decision than what he recommended. If I hadn’t done research then I never would’ve known things I know now.

  8. I definitely prefer to stay within my comfort zone when it comes to investments and whatnot. I am willing to learn, though, but I do like to do my homework before venturing into new territory. I can’t imagine buying a house with no comps. Seems like there is a TON of comps for pretty much any property in our metro area.

  9. Buying the fourplex seems to have become a big ordeal! Knee jerk reactions can tell us a lot, but they should be relied on for important decisions like this.

  10. I definitely see my fair share of knee-jerk reactions working with investments. And while not all the time, but far too often, they are a mistake. An emotional decision made without clearly looking at the facts. I don’t blame you for having a knee-jerk reaction to an ARM, given what did happen to so many people, but I’m glad you took the time to educate yourself and see if it was something you would comfortable with. I’m glad that you’re able to keep moving forward with this rental property but it sounds like a great opportunity for you!

  11. ARMs definitely got a bad rap and I am with you in that I used to hate them, but then when I learned more about them when I became a financial planner and sold mortgages to clients, I realized their value and under the right conditions, they make a ton of sense. Good for you for researching and not just going with your knee jerk reaction!

  12. ARMs can be OK. By the time they adjust, rents may be higher, or property values might be higher. And you are saving from day 1.

    I have used my HELOC many times for short term property loans. Great job!

    If you need any help with finding great tenants, or helping determine of you have a decent one, please contact me!

  13. I have always disliked the idea of ARMS too, but I know a lot of people who have used them to their advantage. Sorry there were no comps for your property! Hopefully that means it will be easy to rent out =)

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