Welcome to Part Two Of
Dealing With Financing of Your Rental

So just to continue on with part two of dealing with financing and how it applies to your current or future rental properties let’s jump right in.

In the first article on the topic we touched on “Why The Basics of Financing Aren’t Basic” and “Why The Bank May Not Be Your Best Option”.

In this article I want to explain some terminology all investors need to know about mortgages and differentiate several mortgage types that are available,  some of the pitfalls of them and then some options to consider with your financing. Before I get there though, I’ll jump into terminology so the rest of the article makes sense

Much of this will be the basics for some of you, so if you’re already familiar with much of this it may seem a bit repetitive, but I’ll try and include some advanced tips in here as well, so hang in there.

 Mortgage Terminology

So much to learn, so little time! I’m going to go over a several important terms to start with and from there we’ll move into the actual types of mortgages.

To start with let’s talk about the different between a mortgage’s amortization period and a mortgage’s term. These two items seem to cause a lot of confusion amongst people and often get misused so hopefully after this you’ll not only know the difference but be the life of the party by being able to correct people when you’re out and about…

So let’s start with amortization!

Amortization or Amortization Period – When it comes to mortgages the amortization period is the length of time it will take to pay off the mortgage. Most mortgages are based off of 25 year amortization periods meaning they will be paid off in full after 25 years if the regular payments are made.

Now while 25 years is typical, you can also find shorter amortization periods of ten or even five years (note depending on the size of the loan these payments will be considerably higher versus spreading it out over 25 years).

Alternatively many investors often look at 30 or even 40 year amortizations where available. Investors often prefer these longer periods as it lowers the monthly payment which in turn increases cash flow, but it comes at the expense of paying much more interest over the entire mortgage.

Above you can find a simple example of how these differences can affect your payments and overall interest paid.

The simplest explanation of amortization period is it’s the full length of the entire mortgage.

Now that you have a grasp about what amortization is, let’s mix it up by introducing terms.

Mortgage Term or Term Period – While the amortization period is the full mortgage length most mortgages these days are broken down into smaller mortgage terms or term periods.

These terms usually consist of three to five year terms, but can also be as short as six months or up to ten years. Thirty years ago and prior the mortgage term was typically the same as the amortization period, but lenders have discovered the longer terms cost them money and they started changing the rules.

By creating shorter terms they are able to usually add some additional fees into the mix, additional mortgage penalties for breaking the term through refinancing or selling of the property and some of the products often tie clients in longer.

While there are additional costs with much of these changes, if you understand how this works, you can also make it work for you. For example, if you know you need to draw some equity out of your property in three years for perhaps a child’s college education or as part of your retirement planning you need to sell the property, you can align your term to fit that timeline.

By reducing the term length to fit your timelines you not only reduce penalty amounts you might incur for breaking the mortgage early, but you often also get slightly lower interest rates.

By default many people simply choose five year terms as they are the most common and they reduce the guesswork of you having to determine if rates will go up or down over the next half decade.

Now that we have mortgage term and amortization under control, let’s talk about open versus closed mortgages.

Open & Closed Mortgages – Open and Closed mortgages refer to your ability to pay the mortgage out without any additional fees or penalties being charged to you if you don’t carry it to the full term.

With an open mortgage you are open to paying it out at any point of the mortgage term. These are ideal for situations where you intend to sell, you’re waiting for additional cash influx from an inheritance, you may be expecting a job transfer out of your current area or you’re expecting a windfall of cash that you wish to attach to the principal of a mortgage or even when you’re waiting to get other finances in order allowing you to qualify at lower rates in the near future.

The trade off for this flexibility though is a much higher interest rate. It’s not uncommon for it to be several points higher or during these very low interest rate periods even double the rate of a closed mortgage.

Closed mortgages have limited options for you to break the term without a significant penalty being imposed. This allows the lender to charge a much lower interest rate as the money is locked in for the duration and if it’s not they get rewarded with the bonus of the penalty.

Closed mortgages are ideal for homeowners or investors with long term plans. You’re trading the higher rates of a open mortgage to staying committed for the mortgage term.

Now that you’re armed with some of the basic terminology regarding mortgages, it’s time to address the two main types of mortgages. These are fixed and adjustable rate mortgages (ARM’s) which are also known as variable rate mortgages in some areas.

Types of Mortgages

Fixed Rate Mortgages – Fixed Rate Mortgages are exactly like the chart I used above with the 5% interest rate. With a fixed rate of 5% (or whatever rate is negotiated) the borrower knows exactly how much they will be paying each month for the term of the mortgage.

This can provide a level of safety and surety for the mortgage holder as they understand exactly what there financing costs are and it allows many of them to sleep very well due to this certainty.

On the other end of this certainty is the next type of mortgage, adjustable rate mortgages.

Adjustable Rate Mortgages (ARM’s) or Variable Rate Mortgages – ARM’s or variable rate mortgages are exactly what they sound like, they are mortgages where the interest rate adjust or varies over time.

Normally ARM style mortgages have much lower interest rates than fixed rate mortgages, but they also come with some additional risk.

These interest rates are usually tied to a schedule which has lower initial interest rates which accelerate later on (these types of mortgages were part of what fuelled the collapse of the US housing market) or to an external rate such as the federal bank rate.

In our current low interest economy this works out as an advantage for investors and homeowners, but if the economy suddenly picks up the federal interest rate could spike upwards causing the monthly mortgage payments to jump as well.

This schedule can be an index fund, Treasury Securities or even a lenders own internal fund. Knowing which fund they are based off of can make a huge difference in how you react if rates do start to change as some indexes or funds will change faster and higher causing you to get hit with much higher payments.

This uncertainty causes a certain spectrum of investors to shy away from these types of mortgages while the lower interest and accompanying payments attracts another breed of buyers who can accept the tradeoff.

Many homeowners and investors hedge this risk by making higher than required payments which go directly towards the principal and if nothing changes help reduce the overall amortization payment often by years!

If rates do go up they are already used to larger payments and also have the option of breaking the term, paying a penalty and locking in a fixed rate albeit perhaps at a higher rate by then.

Now you do need to understand the specific terms relating to the specific mortgage product you’re looking at, but personally I prefer variable rate mortgages where available (and not all lenders provide these on rental properties), as long as the penalties for breaking the mortgage aren’t too drastic.

If the low interest period we’re going through did appear to be about to change my perspective would also change, so be aware of current economic conditions when reading this article.

Your risk and my risk tolerances can be very different and what works for me, may cause many sleepless nights for you! Basically, what works for me may not work for you so consult with qualified professionals, do what makes you comfortable  and don’t blame me if it doesn’t work for you 8′]

This leads me to the final category of mortgages, Hybrid mortgages

Hybrid Mortgages – A Hybrid mortgage is a combination or hybrid of two or more types of mortgages. Usually a hybrid mortgage consists of a lower initial interest rate like an adjustable rate mortgage and after a certain time frame, which can vary from six months to five years, it then adjust to a fixed rate mortgage.

Other variations can be mortgages that combine a Line of Credit (LOC) and a mortgage and as the mortgage principal gets reduced the Line of Credit amount increases.

These can give investors flexibility by providing access to funds via the LOC when needed for items such as repairs. They also tend to lock people in as they are more expensive to transfer out of as they are registered as two debts on the title or deed and each has a cost to remove versus a single cost for a mortgage.

They can also have  expensive increases over time in some cases, so be sure to read the long term affect on your payments and rates!

The important part to remember is each different type of mortgage and it’s variants have specific ways in which they work and they may, or may not, work for your individual situation.

Closing Up Part Two

Again I thought I could wrap everything up here, but it looks like I will need one more article to close up this series.

In the final series I’ll go through some options for investors based on a couple strategies. These will include going for higher cash flow and a second strategy to pay your mortgages down quicker.

Just to close up, I’m including a graph to show you how mortgages are very interest heavy. As you can see in the graph for the first portion of the mortgage the majority of the money you pay for the first third goes towards interest (the orange section of each year) which benefits the lender.

Then in the latter portion the majority goes towards your principal (the green portion of each year), which benefits you! This shows why holding onto a property long term starts benefitting you more and more! Next article we’ll talk about those befits and how you can maximize them even more!

As always, if you have feedback, leave me a comment below and if you found this helpful be sure to share it!

Part Three – Financing Strategies is now up. You can go to it here,

Dealing with Financing – Financing Strategies