Is it a good idea to buy a house with a low ARM monthly payment, then rent it out?

Question

I'm looking around for houses in my college town to rent to others, and I've found a decent 4-bedroom house with an interest-only 5 year ARM monthly payment (of $1700). Assuming I have enough to cover the down payment, would it be a smart decision financially to go for it?

The renting rates for a room in a house like this are typically between $700 - $800 (the house is very close to campus in a nice neighborhood), meaning at a minimum I will be making around $1100 a month excluding landlord / property fees ($2800 a month total minus the $1700 of interest I'm paying). I know next to nothing about purchasing real estate, but this seems like this could be a decent way to make a little bit of money. If I were planning to sell the house after 5 years, would this be a smart decision?

EDIT: I was being a little unclear I guess. I will be renting the house out for a minimum of $2800 a month (4 bedrooms at $700 a room or more is very common in the town I live in).

Answer 1

revised after your edit

You'd be potentially earning $8-10K a year after property taxes (before income taxes), and getting the balloon payment in 5 years. Add to that maintenance fees, you would have a $30K cushion allowing you to sell at $30K loss to break even. So if you sell at gain - you made some money.

During the last 5 years the prices fell by 25-50%, so people who tried this trick 5 years ago are in a very bad place right now. You have a very good chance to join them. However, if the prices are to go up and you are able to sell the property in 5 years, you can make some gain.

At current ARM 5/1 rates (3.125% according to zillow mortgage marketplace), it looks like you're borrowing ~$655K, which makes it $850K purchase. Prices go down 5% - you lost all your profits. Prices go up 5% - you doubled it. Quite a gamble, I'd say.

I think that its insane, for someone who has no idea in real estate, to spend $200K in cash and more than half a million in liability, that's what got us into the housing market collapse to begin with.

in addition

A point made by @mhoran_psprep is depreciation.

For a $850K you're writing off $30K a year depreciation. That will be recaptured when you sell, i.e.: if you sell for the same price as you bought it for, you're going to have $150K capital gain on your hands. Which in turn means, assuming current long term capital gains rates, $22.5K tax bill. Current rates are for this year only, and if expire - the tax bill is going to be even higher. $30K cushion we calculated above? Paid to Uncle Sam. Pufff, gone. You're with 5K left of it, for 5 years period of investing your $200K cash. That's 0.5% annual ROI. HORRIBLE. You can put your $200K in a savings account and get higher guaranteed returns. And that's with a reasonable scenario of prices staying more or less flat in the next 5 years.

Answer 2

Others have addressed the financial aspects but I also wanted to add that you should only consider this if you want to add "Landlord" to your resume.

In general being a landlord can be a big job, when you include finding tenants, working with them, and maintaining the house (which is an unknown as this house is new to you). When you add in the fact that you may have 4 separate tenants at once, who are students, it really complicates things.

You will have to:

• Find these student renters
• Hope they can pay rent after buying their textbooks
• Maintain/fix every little thing in the house, since students are inexperienced at home repair
• Get called at 4am when a drunk friend breaks something

And then find new renters every year or even every semester.

If you think it'd be interesting to be a landlord, go for it, but go into it eyes-open. You should check your budget to verify that it provides compensation for your new part-time job.

Answer 3

Risks:

• The 1700 monthly payment for Interest only ARM, does that include taxes and Insurance? If not it will cut into your profits.
• There is no guarantee that you will rent all four rooms each semester.
• If you don't sell in 5 years - what is the worst case for the interest rate? or is there a balloon payment?
• Does the mortgage company know you will not be living in the house? They may require that the property by owner occupied.
• You will not be gaining equity so you must be able to sell it for your purchase price plus closing in order to make a profit.
• Also note that the government could say you made a profit, if you sell for more than the depreciated value. They will expect you to pay taxes on this profit, even though it could be less then the loan balance.

Answer 4

There are two reasons not to do this:

1. Five or less years is probably not long enough to own a property. The fixed costs of buying (closing costs) and selling (real estate agent commission) are likely to make the deal unprofitable.

2. Doing so via an ARM (assuming you could even get one for an investment property) adds additional risk to the equation. If, at the end of five years, your property has not gone up enough to cover the agent commission, taxes, etc you may be stuck in the property. But then your ARM may be about to get reset to a higher rate. You may end up in a damned if you do (sell), damned if you don't situation.

If you can reconsider the deal so that you can do it with a fixed rate loan, and plan to hold the property for a longer time period, it sounds like it could be profitable.

Answer 5

Why not run the numbers with a fixed 30 year mortgage? The 30 year rate is still about 4%. The money saved by going 5 year arm is too small compared to the risk of rates rising over the next 5 years and the first reset of rate is a shocker. If the numbers work based on cash flow using the 30 year fixed, then be sure to track the depreciation issue as others pointed out. Simply put, you can sell in 10 years for what you paid, but have a sizable cap gain (really, recapture of depreciation) and that can hurt.

One bit of advice - don't count on all four rooms always being rented. What if one year you only get three? Plan for the worst scenario.

Answer 6

While I am in agreement with others that the OP should think twice before getting into this deal, I am a little puzzled by the issue of depreciation of the rental property and why getting stuck with a large bill at the end of five years is as bad as people think. If $30K per year is written off to depreciation, the rental is likely to be showing a loss each year on paper though not in terms of cash flow. In fact, the taxable income in each of those years will be smaller and so less will be paid out in income tax. If at the end of five years, the property is sold for exactly the price at which it was bought (or even higher), all that depreciation will be recaptured and there will be a large capital gain. But, hasn't the transaction effectively changed $150K of regular income over 5 years into $150K of long-term capital gains which are taxed at a lower rate, and, furthermore, deferred the payment of the lower tax by five years while having had the use of the tax refunds in the meantime? While this may still not work out to be a good deal, I think the mere fact that there may be a large amount subject to capital gains tax after 5 years is not by itself sufficient to kill the deal. I think the numbers need to be considered more carefully.