This is a story about an ant and a grasshopper. Both the ant and the grasshopper wanted to buy some rental houses as an investment. The grasshopper was a little older than the ant, and had been around the garden a few times. The ant was an upstart of such, knew more than the grasshopper -- or so he thought -- and was always just a little bit, oh, "cocky." Cocky is a very good term for this ant.
Just about 18 months ago, when interest rates were at some of their lowest of all lows, the ant and the grasshopper saw an opportunity to buy some rent houses in a college town. The houses were close to campus, were recently built and were most all rented out. And being the wise orthopteroid he was, the grasshopper was a tad more conservative than his brash ant-buddy.
But one thing they could agree on, they both agreed to get their mortgage from me. Having been in the mortgage industry for a long, long time and knowing when to lock in low rates, I suggested they both take a fixed product.
The ant wanted the newest mortgage model available, the Interest-only, Payment Option ARM based on Prime plus 1 percent. Not only was the fully indexed rate at 5.00 percent, he could pay interest only or the fully indexed payment. That mean that, at his choosing, he could decide whether or not to cash-flow in any particular month.
The grasshopper didn't want to have anything to do an ARM. He's seen too many rate swings and remembers when rates for rent houses were in the low 20s. He chose a 30 year fixed rate, which was at 6.25 percent at the time.
The facts: The homes were nearly right next to one another and sold for the very same price: $165,000, 20 percent down, and borrowing $132,000. The houses, when rented, took in $900 per month.
Because the ant's monthly payments could be as low as $560 per month, he was pulling in $340 per month, not counting taxes and insurance. The grasshopper's monthly payment was $812, only making $88 per month.
The ant was pulling in more than $250 each month more than his stupid old grasshopper friend. At least for a short while. Then some human started raising rates. And each month his payment went up but his rent income stayed the same. Now his Interest-only payment is $935. He's losing $35 per month. And the rumor in human-land is that interest rate increases aren't over. That soon his payment could be as high as $1,017. And that's his interest-only payment.
If he made his payment on a fully amortized basis, it would be closer to $1,085 per month. But the ant never did, he always made the minimum payment each month, never paying down his principal for the sole purpose of spending his money on ant-like things such as fancy watches or going out to dinner all the time. He never planned ahead.
Not like the grasshopper. Our grasshopper had seen interest rate mood swings before. He knew a good rate when he saw it … an investment property fixed interest rate at 6.25 percent. For 30 years. Fully amortized.
When rents started to increase, he made that much more because his payment would never change. But not the ant. The ant lost money each and every month, his loan balance never went down, and had actually grown because he never made a fully indexed loan payment.
His 20 percent down payment was nearly eaten up by unpaid principal being added to his original loan. He never saved for the future, and spent all his savings. The ant suddenly died of an apparent, albeit small, heart attack. The grasshopper is taking advantage of distressed properties about to go into foreclosure and is one healthy insect.
