Let me first say, that once a financial planner, always a financial planner.
Although I go around these days disguised as a licensed mortgage and real estate broker, I am also a practicing Certified Public Accountant with more than 13 years experience. I have provided many hours of comprehensive financial, tax, and estate planning services to many clients over those years.
Since becoming a real estate and mortgage broker, I have discovered an area of personal finance that is so underutilized, so misunderstood and that receives very little attention in the overall scheme of financial planning. It is an area that, if properly planned and utilized, would most definitely result in a substantial wealth accumulation over time. The real estate and, more specifically, the HOME MORTGAGE arena is where I have landed.
A person's home is very likely the most valuable asset in which they will ever invest. Most who purchase a home do so by borrowing money. Nothing surprising there. However, little thought is given other than "what's the rate?", "how much will my payments be?" and "how soon can we close?" to this very important matter.
So, that's where the MISSED FORTUNE lies. I didn't come up with the term "Missed Fortune" but no words better describe what is going on in this process.
Our parents' and their parents' financial advice to us was primarily based on the premise of saving money and staying out of debt. If you had to go into debt for whatever reason, you were taught to get out of debt as soon as humanly possible. That was sound advice in their day and still holds today in many but not all cases.
However, we live in a much different world today. Most people don't save nearly enough. Most homes are sold within 7 years of purchase. Most mortgages have a lifespan of about 4.4 years and still the most popular mortgage is the 30 year fixed rate. Hmmmmm?
We simply don't stay in the same house or work for the same companies for 25-30-35-40 years the way the previous generations did.
HOWEVER, we still use debt the same way our parents did. Why is that?
We MUST become smarter in the way we employ our assets. We are either spending our equity or allowing it to lie dormant in our homes and missing a tremendous opportunity.
Here's typically what happens...
We purchase property usually with a 30 year traditional fixed rate mortgage. We make our monthly payments, paying down our debt (increasing our equity) ever so slightly. From time to time or for some, every month, we send our extra savings to the lender. This makes us feel good because that's what our Dads and Grandads said we should do. Mr. or Ms. Banker feels good, too. You just gave the bank free money to lend.
Question: What happens to your payment amount on a traditional 30 year fixed rate mortgage as you pay down your loan?
Answer: NOTHING! IT STAYS THE SAME! And this is the part that most people like?
Back to the story...
Then comes the rainy day. We need some cash for our daughters' college expenses. We want to install a pool or make other home repairs. We have to make repairs to our auto. Whatever.
So, what do we do? We go back to the bank and meeting with the banker and say, "Ms. Banker, you know that money I've been paying extra on my loan? Well, we have this special need for a few thousand bucks and we'd like it back. A home equity loan would sure come in handy." Ms. Banker smiles broadly (thinking I just hit my quota for the month) and says "Great! Let's first see if you qualify." And you are thinking, "Qualify? But I thought it was my money?"
If all goes according to their strict banking guidelines, she'll reply, "Just Sign Right Here!!" and will gladly LEND you YOUR money. And the most puzzling fact is that you are glad to get it!! It's your money!
Or let's say we don't borrow that money right away. We leave it in the equity of our home. Then we retire. We have a home owned free and clear, completely paid for, but no income to support the payments required in order to borrow and repay your equity.
So, we work all of those years, pay down our loan balance, giving the bank an interest free loan until we decide to sell the house. Then, they may or may not give us the cash back depending on whether we qualify? What a great deal, huh?
No, it's not a deal. It's not a great deal at all.
Here's a numerical example:
House 1 and 2 are identical in every way.
House 1 is valued at $375,000 and is owned free and clear.
House 2 is located next door to House 1 and is mortgaged 100%.
Those homes appreciate 10% in a year. At the end of the year, both properties will be worth $412,500 without regard to the debt. Right? Both enjoy a 10% increase in value from a strong market. So, proof number 1 that debt has no effect on the value of real estate. Agree? I didn't say equity, I said value.
"But I have to finance my house using a 30 year fixed rate mortgage because...well...that's what my Dad had and I am afraid that rates might go up."
Ever heard that one before? Ever said that before? Let's look at this example.
Same properties, with the same assumptions, except they both have $300,000 (80% Loan to Value ratio - value is $375,000 and mortgage is $300,000) mortgages on them. Taxes and insurance are excluded from this example as those costs would be the same for both properties without regard to mortgage balances.
House 1's mortgage is a fully, amortized 30 year loan @ 6.0% interest rate and hte principal & interest payments are about $1,799 per month.
House 2 is an Interest-Only 5 Year Adjustable Rate (ARM) mortgage loan @ 5.75% with a monthly payment of $1,438, a savings of $361 per month.
Point 1...so-called "traditional" mortgages are "front-end loaded", meaning that the borrower repays very little principal in the first few years of the loan. Don't take my word for it, look at your monthly statement or your amortization schedule.
Point 2, the average mortgage loan has a life of less than 5 years. Actually, it is 4.4 years. This is the primary reason I use the 5 year ARM in my example.
Now the investor/borrower has OPTIONS...three (or more) choices of what to do with her monthly savings. We are talking about the same dollars that would be spent if the borrower chose a 30 year fixed rate mortgage.
Choice 1 - use the monthly savings to pay down the principal balance of the mortgage. This is the equivalent of putting the money under your mattress.
Choice 2 - set up a side fund at a mutual fund or other investment in which to invest the difference. In 5 years, at an annual return rate of 8% (which is a relatively safe investment return), the side fund balance would be more than $26,500. The borrower wouldn't have to go out and borrow the funds in the event of a rainy day because it's her money.
Choice 3 - utilize the savings to repay other debts. Got credit card balances at 14, 16, 18+%? Make them disappear. People everywhere are willing to borrow on credit cards at 18-24% but balk at borrowing at 6-8% on a home mortgage.
All examples assume a tax rate of 25%.
I will ignore Choice 4...which is to just go out and blow the savings. That should never be an option and will not be included in my analyses.
Where's the risk?
Chosing the "believed to be more risky" adjustable rate mortgage results in a net savings over the 5 years of $4,198 or an average of $840 per year. Remember, a 5 year adjustable rate mortgage doesn't adjust for 5 years. There are also 7 and 10 year options.
Investing the savings results in a side fund balance of $26,525 after 5 years.
Assuming the mortgage will follow the 4.4 year pattern, there is ABSOLUTELY NO INTEREST RATE RISK in a 5 year Adjustable Rate Mortgage. Zero.
And if the borrower does refinance the mortgage in 4.4 years (as is usual), there is no increase in interest payments.
Extrapolated further, the results would be much greater.
Pay Option ARMs, those loans that sound "too good to be true", that have been unfairly characterized in the press because they are negatively amortizing loans (meaning that the loan balance grows through deferred interest) and that allow the borrower to make payments as though your interest rate is between 1% and 3%, result in even greater differences over the term.
Properly utilized, a pay option ARM can help the borrower achieve greater wealth than he will ever achieve with the standard 30 year fixed rate mortgage.
So, you see, with the proper use of debt, the good kind of debt, mortgage debt that is still subsidized by the federal government by way of the deductibility of home mortgage interest expense, individuals can pay off a mortgage much faster or accumulate more wealth with very little risk by utilizing the mortgage products available and low risk investment vehicles.
Now, granted, doing this requires discipline on the part of the borrower(s). If the borrower simply spends the monthly savings and fails to save, this will not be as good of a deal for them. However, it would be no worse that a traditional fixed rate mortgage and he'll have a lot more fun in life. As far as negative amortization loans...property values in our area have far outpaced the negative amortization on these products. So, where's the risk?
Understand your options, because, believe me, there are options. Call me for more information and a personal analysis of your mortgage situation. Email me at kpearce@CPALoanPro.com to set request an appointment for a complete, no obligation mortgage analysis.
Keith Pearce is a Florida-licensed CPA, real estate and mortgage broker.
The definition of insanity is doing the same things over and over, expecting different results.