Question: I have an existing single-family residence we'll call Property #1. It has three bedrooms, two baths and is financed with a $450,000 option ARM. I make $1,700 a month in rent from the property. In July of 2006, I purchased a second property. Property #2 is a tri-level townhome in which I currently live. The second property is brand new and I have a $467,000 first mortgage plus a $57,000 home equity line of credit. I make $1,200 per month in rent on this property which also has an option ARM on it. The current value of property #1 is $550,000. The second property has not appreciated much.

I was going to specifically use option ARMs as a tool to maximize my cash flow for 12 months, knowing that I was likely going to put Property #1 on the market prior to the loan payment re-set. I would take the proceeds from that sale, and pay down Property #2. Sounds like a familiar plan right?

Well, with the market cooling and with the negative amortization I'm incurring, I'm looking to make a mortgage change ... and fast. I believe that Property #1 will not sell quickly so I'm trying to figure out what my next move is. Obviously, refinancing into a fixed-interest loan makes sense but I cannot afford the monthly mortgage difference on both properties, after rent has been figured in.

I feel a bit stuck, scared and concerned. Since the next move I make could shape my financial future for years to come, what should I do?

Answer: Let's look at the properties individually.

Property #1 produces $1,700 a month in rent and has a $450,000 option ARM. With an option ARM you can typically make monthly payments for the first five years based on a 30- or 15-year amortization rate, interest-only payments or payments which are low, insufficient to cover the interest bill and result in negative amortization.

At $1,700 a month you take in $20,400 a year. Assuming -- ridiculously -- no costs for taxes, insurance, maintenance, vacancies or other expenses, then your entire rent is equal to 4.5 percent of the mortgage.

You say property #1 is now worth $550,000. That's $100,000 more than the original loan amount. However, the loan amount is probably growing each month because of negative amortization; when you sell you will have marketing and closing costs; and -- lastly -- in a cooling market it may be that significant concessions will be needed to effect a sale. If this analysis is correct you will not walk away from closing with anywhere near $100,000 ($550,000 less $450,000).

If you cannot comfortably hold onto Property #1 with income from other sources or by getting more rent from the property, then the only reasonable choice is to sell now before what equity you have is devoured further by negative amortization and falling prices. If the present pattern continues, then keeping the property will inevitably produce an "upside down" owner and result in foreclosure and bankruptcy.

Property #2 presents a somewhat different set of issues. Here you have roughly $525,000 in debt, the bulk in the form of another option ARM. You're taking in $1,200 a month in rent plus you occupy the property. If you moved elsewhere you would still have to pay rent or a mortgage, so your occupancy (the use of the property) has an economic value that offsets some portion of your monthly mortgage costs.

The best strategy here is probably to take such money as can be salvaged from the sale of property #1 and pay off the line of credit on house #2. Then refinance the first mortgage to a fixed rate if the combination of the rental income and an allowance for your occupancy can be justified.

Before going further check with local brokers and ask them to look at the market values of both properties. Also ask if they can recommend lenders who might be able to provide fixed-rate financing.

Question: I have an interest-only adjustable rate mortgage. My interest rate has climbed from 3.4 to 6.98 percent within last two years.

I'm paying interest only and occasionally my loan is subject to negative amortization.

It looks like the index is climbing up and predictions for the next six months are not showing any decline. What type of refinancing should I get?

Answer: If you have an interest-only loan, perhaps for the first five years of the loan term, it means the principal balance of the loan is not being reduced. By definition, if you just pay interest there should not be "negative amortization" -- the addition of unpaid interest to the mortgage balance. If your loan is allowing negative amortization then what you have is not an "interest-only loan" but instead an "option ARM," a mortgage format which allows a variety of payment choices, including the option to make monthly payments so low that not even interest costs are covered.

What you have is a potentially toxic loan. If you're bothered by an interest rate which has merely doubled from 3.4 to 6.98 percent then wait until the loan's "start period" ends and you must make fully amortizing payments each month.

How bad could this get? Imagine that you have a $200,000 mortgage. With an interest-only payment at 3.4 percent you will pay $567 percent month. Raise the rate to 6.98 percent and the interest-only monthly cost grows to $1,163.

Of course, you can't make interest-only payments forever. If a five-year start period ends you will have 25 years remaining on the loan. Assuming an interest rate of 6.98 percent for the next quarter century with no rate increases and assuming that the loan amount has not increased as a result of negative amortization, your minimum monthly payment for just principal and interest would be $1,411 per month -- almost three times current costs given very conservative assumptions. If interest rates rise or negative amortization increases the loan amount then your monthly costs could be vastly larger.

Can you afford such higher costs? If not, see if refinancing with a fixed-rate loan makes sense. However, if the monthly costs of a fixed-rate loan are too much then you will need to sell before the property is foreclosed.

Question: What are your thoughts on reinvesting. My home is paid for but I'm single and don't get much of a tax break. Is it wise to obtain a mortgage for, lets say 6 percent, and reinvest the loan amount hoping to do 6-12 percent or better?

Answer: Arbitrage is generally seen as benefitting from price differentials. If you get a 6 percent mortgage and can reinvest the money for more than 6 percent then in terms of arbitrage you would be ahead.

However, arbitrage is a theory. While the debt from refinancing is real and absolute, you don't know and cannot assure that you will actually get a return above 6 percent. You could have a principal loss. You could only make 5 percent. Or 2 percent.

If you have stock market profits you must pay a tax on any winnings. Meanwhile, if you have a loss on your personal residence that's not deductible -- see a tax professional for specifics.

Your mortgage-free home actually produces an economic benefit, it is not an idle asset: Let's say that you could finance your property for $300,000 at 6 percent with a fixed-rate, 30-year mortgage. The interest cost in year one would be roughly $18,000. However, since your home is mortgage-free you do not need to come up with $1,798 a month for principal and interest. The monthly payments you do not have to make are a huge -- and tax-free -- "savings."

If you want to invest, why not take a portion of your monthly savings, say $1,000 in this example, and invest that money in the stock market? That way if you get good returns, great. If you have a loss it will not impact the ownership of your home.

Question: We have lived in our house five years. We just refinanced and now due to job we're going to sell our home. What happens to our loan?

Answer: When you sell the property any existing loans will be paid off from the proceeds at settlement. In other words, if you have $100,000 in mortgage and sell the property for $350,000 then the cash you receive at closing will be reduced by $100,000 to pay back the loan plus other money to pay off closing costs, other liens, brokerage fees, etc.

By any chance does your loan have a prepayment penalty? If so, how much? This penalty will also be paid off at closing.

Question: I want to know exactly where the property line is between my house and my neighbor. My sister told me it doesn't matter because it's not much to care about and I would have to take care the grass. Do you think she's right? If she isn't then what should I do to re-measure my property?

Answer: To determine your property's exact boundaries you want to get a survey by a licensed surveyor.

Knowing the precise boundaries of your property is important. First, you want to assure that you're not paying taxes on property used by a neighbor. Second, if your neighbor continuously, openly and notoriously uses your property, he may actually obtain title over a number of years. Third, when you sell you want to assure your buyer that they are getting a given quantity of property and that the boundaries of that property are well defined.

A Note of Thanks

This column would not be possible without the terrific work done by Ed Armenta and Robert Jennings. Each day they sort through huge volumes of email and forward only those items with the most potential for use in Ask Realty Times. Because we can only respond to a small portion of the thousands and thousands of emails we receive, we look for questions which have the widest application for most readers; illustrate a real estate principle; provide a platform to examine an idea in depth; or reflect current news trends. It takes a lot of discretion to make such decisions and to their credit Armenta and Jennings always display great skill, strong empathy and solid judgment reviewing reader letters.

Have a real estate question? Send your inquiry to Ask Realty Times. Because of the volume of mail received, Mr. Miller cannot respond to questions individually or privately. Published letters may be edited for space and style. For comments regarding other Realty Times articles, please contact individual authors by pressing here. For past columns, please press Ask Realty Times.

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Published: December 22, 2006

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Have a real estate question for Realty Times? Wondering about buying, selling, financing, refinancing or renting? Here's where you can send your question to Peter G. Miller, OurBroker®, a nationally-known columnist, author and reporter. Peter G. Miller has written six books -- including The Common-Sense Mortgage -- a guide with hundreds of thousands of copies in print. Miller was the original creator and host of America Online's Real Estate Center and joined Realty Times in 1998. Send your questions to . Because of the volume of mail received, individual questions cannot be answered privately and not all questions can be used. Published letters may be edited for space and style and all letters become the property of Realty Times upon receipt.