There are a whole series of catchy names for the product that we advocate and call the New Smart Loan™.
Others call it the ''Option ARM,'' ''Cash Flow ARM,'' ''Choice Pay,'' ''Flex Pay,'' ''Personally Tailored Mortgage,'' the ''Mortgage Stretch, '' and ''Advantage ARM.'' All amount to more or less the same mortgage product.
New Smart Loans™ are suitable for real estate investors for a number of reasons. First and foremost, they offer one of the best opportunities to leverage a mortgage with the aim of converting home equity into usable cash. They do this by providing a good deal of flexibility on monthly mortgage payments. It is the kind of flexibility that borrowers have sought for a long time but could not get until recently and this flexibility also allows the borrower to become debt free and have cash flow at the same time.
There is no need to be house rich and cash poor—not with the availability of the New Smart Loan™.
STRATEGY # 12:
USE LEVERAGE TO CREATE ''GOOD'' DEBT.
The way to create ''good'' debt—the kind of debt that leads to wealth creation—is to use leverage. This may sound risky, but it is the tool that is going to bring you the profit that you are looking for. If you do not use leverage in a real estate transaction, you might as well buy a bond, because it's the leverage that increases your return on investment and increases your yield.
The New Smart Loan™ is one of the most popular of the adjustable rate mortgages (ARMs). Its main feature is that it permits the borrower—you—to choose what payments to make on the mortgage each month. Different lenders may call ARMs by different names but they share one thing in common: the interest rate can and probably will change periodically during the life of the loan.
For most ARMs, the starting or initial interest rate is frequently lower than the interest rate for a fixed rate mortgage. It is the lender's way of offering the borrower an inducement to take a risk as to whether interest rates will rise or fall.
What Is an ARM?
An adjustable rate mortgage doesn't have fixed rates, but rather has rates that change over time. It has what is called the ''adjustment period'' of the loan, the period between one interest change and the next. A typical adjustment period might be six months or one, three, or five years; six months and one year are the most common.
The interest rate is usually higher on longer adjustment peri-ods—because those adjustment periods are considered more sta ble. For the person who wants to remain in a house for only a few years, longer-term adjustments make sense. It's then possible to exploit the lower overall interest rate on a three- to five-year ARM (as opposed to the higher-rate, fixed mortgage) and still have a high degree of stability.
Anyone who takes out an adjustable rate mortgage has to take into account that the rate (and payment) could rise at some point.
While there are all sorts of ARMs, they all base the interest rate on some index plus a margin. Lenders choose a financial index as a guide in calculating the periodic interest rate adjustment. If the index rate rises, so does the interest rate on the mortgage; and, consequently, the monthly payment increases. If the index rate decreases, both the interest rate and the monthly payment decrease.
Choosing an index can make quite a difference when the adjustment comes, as some indexes are more volatile than others. Lenders can use any of a number of indexes, but the lender must tell the borrower before signing the mortgage contract which index will be used. The most common indexes are the rates on one-, three-, and five-year U.S. Treasury securities, and the Federal Home Loan Bank Board's national or regional average mortgage rate.
The margin is an additional amount that the lender adds on to the index rate (usually from one to three points); it is constant for the life of the loan.
Interest rate caps and payment caps may apply to some loans. They ensure that abrupt and drastic increases in the index will not make monthly payments unaffordable. They are ceilings of a kind and come in two formats:
If you had a 2% periodic cap and a 5% overall cap on the mortgage's interest rate and the index rate climbed 3% in the first year, the interest rate would increase by only 2%. If the index rate continued to climb in subsequent years, once the interest rate reached a 5% increase it would not go any higher. Because of the reduced risk provided, however, lower periodic and overall caps can be accompanied by a higher initial interest rate.
Payment caps limit the amount the payment will increase or decrease, usually in terms of a percentage of a previous payment. Here's an example: on a $50,000, 10%, 30-year mortgage, a 2 percentage point increase in the interest rate could increase the monthly mortgage payment from $438 to $513, a 17% increase in the payment. If you had a 7.5% payment cap, however, the payment could increase to no more than $471 during the first adjustment period, a savings of $42 per month. Think of New Smart Loans™ as a set of mortgage payments, with varying monthly mortgage payments, and with varying ways to build wealth.
To appreciate all that a New Smart Loan™ offers, let's review precisely what a mortgage is and what it does:
A mortgage permits a borrower to amortize, or pay back through regular payments, the principal borrowed from a lender. Part of each regular payment is the interest; the balance of the payment is used to pay back the principal. The principal, or loan balance, decreases by the amount of the principal part of each payment. Sometimes the borrower might experience what is called negative amortization; that happens when payment is not large enough to pay all the interest due. This results in an increase in the principal due the lender.
What Is Negative Amortization?
The notion of negative amortization is very important for everyone to understand before we delve too much more deeply into smart loans. The negative amortization mortgage is one of the most popular options within the New Smart Loan™ program.
Negative amortization happens when a payment or interest rate cap keeps the actual monthly payment below the level required by the market interest rate. Because the borrower has not paid the full interest charge in the monthly payment, the unpaid interest is added to the remaining principal that is owed. This causes the outstanding balance to increase rather than decrease.
Depending on the terms of the mortgage program, the financial institution may extend the term of your contract by a year or two or calculate subsequent payments based on the new, higher, outstanding balance.
BE DISCIPLINED WITH YOUR NEW USABLE CASH; DON'T FRITTER IT AWAY ON BOATS AND VACATIONS.
We must make one caveat before continuing our discussion of negative amortization: the whole point of one of these New Smart Loans™ is that the borrower will have more and more usable cash on hand. But, for the borrower to become a continuing investor, he or she must exercise tough discipline on the way that usable cash is handled. If you take the cash out of the property and then go off to the track and bet on the horses, that usable cash is going to be wasted. You will be defeating the whole purpose of leveraging mortgages into wealth creators.
These mortgage instruments are not designed for people who are going to ''waste'' any newly found, usable cash by purchasing items that make them feel good in the short term, but prevent wealth creation over the long term. They are designed for the person who wants to take that newly found cash and put it to work, to employ that money in smart forms of wealth creation.
Four Main New Smart Loan™ Options
Although there are many different mortgage options under our New Smart Loan™ arrangement, the four main ones, varying in one way or another by the amount of monthly payments, are these:
You pick the financial index that will be used and tied to the loan (plus a margin determined by the lender). Remember, the index plus the margin equals the interest rate.
The savvy real estate investor would most likely choose the New Smart Loan™ program and pay the minimum payment. That allows him/her to have more usable cash available. The money could be put to any use: a college savings fund; investing in the stock market; starting a mortgage savings account (also known as a sinking fund); or investing in other properties.
Over time, money put to these alternative uses will accumulate and compound, while utilizing the minimum monthly payment.
Generally speaking, the longer the term of the loan, the lower the minimum monthly payments will be. Many choose a mortgage with a longer term, and a lower monthly payment, to make the mortgage more affordable. Longer mortgages mean higher total interest cost, but only if the borrower retains the mortgages for the full 30 years.
Figuring Out Which New Smart LoanTM Is Right for You
Use a Total Cost Analysis to make comparisons among the four main kinds of mortgage instruments: a minimum-payment mortgage, an interest-only mortgage, and a 15- or 30-year amortization mortgage. A Total Cost Analysis makes the comparison between multiple mortgage instruments side by side. Here's an example broken down for each mortgage type so you can compare.
Let's suppose that we are taking a $200,000 mortgage on a property worth $250,000. Within the New Smart Loan™ program, here are our options:
Sometimes people incorrectly believe that choosing an interest-only payment means never having to pay off the mortgage. That is simply not true. You can pay off your mortgage—and even do it faster. Here's how:
The difference between the $667 and the $1715 monthly payments is roughly $1,000. If you take that $1,000 a month and invest it with a 5% return, at the end of five years, you will have $72,000.
If you refinance your property at the end of that first five-year period, taking 80% of its new value ($320,000, the new loan amount would be $256,000, assuming a 5% appreciation per year), you would have $56,000. That would result in a total cash return of $128,000 (the $72,000 pus $56,000 comes to $128,000). A sum of $1,000 per month equals $72,000 for the second five years.
That means that over ten years, you have $236,000 working for you outside the boundaries of your mortgage obligations.
This does not mean that you have to make mortgage payments with the idea of paying off the mortgage; it simply means that you have the ability to pay it off after ten years. Had you taken a fixed rate mortgage on the $200,000, you would have had no extra money for investment purposes.
The point to be underlined here: It's advantageous to use these different kinds ofmortgage programs to increase your available cash flow.
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