Monday, April 15, 2013

Mortgage Choices Often Emotion Driven - Here Are the Cold Hard Facts

English: Mortgage debt
English: Mortgage debt (Photo credit: Wikipedia)

Mortgage Choices Are More Often Informed by Emotion Than Financial Analysis

Are you risk averse, or do you love to draw to inside straights?  We are all blessed with different personalities, different circumstances in life, and different life lenses that effect how we make decisions.  In the realm of financial decisions, our emotional response to risk often colors our decision as much or more than the cold, hard financial facts.   That doesn't mean that the emotion isn't correct. In fact, I think the emotion trumps any of the financial issues.

But my goal as a mortgage broker and consultant is to give you a complete understanding of how all of these numbers fit together so you can make an informed choice.

For instance, many people call me and say they want to get a 30 year fixed.   They want to put 25% down or even a larger down payment, because they want to make small monthly payments. I understand that.  They may fear that somehow having mortgage insurance or having larger monthly payments is a bad idea.

The Cold Hard Mortgage Numbers Provide Surprising Results

I'd like to draw that back and show that the numbers indicate differently.   Not only is having a larger payment and even paying mortgage insurance not a bad idea, but arguably is a very wise thing to do. What many don’t consider is the concept taught in every business class and business school.  I know I had to hear it repeatedly at Wharton.  The concept is known as “opportunity costs.”   If you invest your money in A, there's an opportunity cost arising from the reality that you don't have the money for future purposes, either to spend, or to invest in B, C, or D.

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Large down payments result in lost opportunities to invest that money in alternate opportunities.  

I'll use a real life example of a client who recently bought a four unit building here in Los Angeles with a purchase price of $1,200,000.  They can move into the building and live in one of the four units rent free.  They are faced with choices.  Because this building will be a primary residence, one of their choices is to put as little as 3.5% down, which is $42,000, and get a government insured loan by the FHA.  You can also get low down payment loans through private sources with as little as 5% down on most transactions, and get private mortgage insurance.  In general, private mortgage insurance is about 20%-25% the cost of an FHA insurance.

FHA charges you up front; private mortgage insurance doesn't. FHA charges you a much higher per monthly fee than private mortgage insurance.  And FHA mortgage insurance will stay on your loan for at least five years and potentially longer.  With private mortgage insurance you can get rid of it after just two years.

These guidelines change, and private mortgage insurance won't do every kind of transaction, whereas the FHA is much more generous.  However, the concept is the same. You put down very little money and borrow much more.  Mortgage insurance is an expense.  It's even arguably an odious expense. It does, however, let you accomplish a great deal more with your money than without it.

Now back to the specific situation, my client is buying the four unit building, living in one unit, paying the cost of $1,200,000.  We examined the option of putting 25% down, which is $300,000, and he would have a mortgage of $900,000.  The $900,000 loan with an interest rate on a 30 year fixed is currently about 3.875. No mortgage insurance.  The client would have the same payment each month for the life of the loan. Somewhere on the order of $5,800/month.

We then contrasted that to doing an FHA loan.  The FHA down payment is $42,000, or 3.5%.  So he would be borrowing $1,158,000.  The cash left difference between the two down payments would remain under the control of the client by using FHA and equals $258,000. That's a key figure to keep in mind. With the FHA insurance, he's getting a lower interest rate of about 3.25%.   He'll have mortgage insurance, which is quite expensive on that particular transaction. He's going to be paying a little over $1,200 per month for the mortgage insurance, and he'll pay that for five years.

So when you get done taking into account the higher mortgage payment, based on a higher loan balance and the mortgage insurance, he's paying roughly $7,900 per month. If you look at these side-by-side and I say "would you rather pay $5,800 a month or $7,900 a month?"  You look at me and say it's a no brainer.   For now, we will not consider the tax advantages and tax effects.

However, here's why the analysis goes the other way, financially speaking.  We now looked at what else he could do with that $258,000 cash that was not used for the FHA down payment.  That's the opportunity cost

What can he do with that money?  For many people, investments in today's markets aren't so great.  You can get a CD, pays about 1% per year. You can buy some tax free bonds and be in the 2 or 3%. But by working with a financial adviser you are likely to be able to get a very secure investment that's paying 3% - 4%.

Return On Investment at 4% on Money Not Used for the Down Payment Is Outstanding.  What about 8%?

To fully investigate this alternative approach it is critical is to think down the road.  You're looking at a purchase with a loan that's a 30 year term.  Today, investment returns maybe aren't that great, but the economy is still in recovery mode.  A few years down the road, certainly statistically, one could expect to be getting interest rates of 7% to 8%.

But let's deal with a more conservative approach.  My client takes that $258,000 dollars and puts it into a safe investment and makes 1% a year. We looked at five, ten, and fifteen years down the road. In15 years, if you compound interest that $258,000 at 1% one time per year, that money is going to grow from $258,000 to $299,000, which is not that impressive.  The compounding is where the
English: Albert Einstein Fran├žais : Portrait d...
English: Albert Einstein Fran├žais : Portrait d'Albert Einstein (Photo credit: Wikipedia)
impressiveness comes in. To paraphrase a famous quote from Albert Einstein, "compound interest is the strongest force in the universe."

We looked at every interest rate from 1 percent up to 12 percent.  Finally we used a very conservative number of 4%.  His $258,000 after 15 years compounded once a year at 4%, is $464,000.  What we're looking at, finally, is putting $300,000 dollars down to get a $900,000 mortgage and not having money in the bank, or putting $42,000 down, getting a loan of $1,158,000, and sticking $258,000 in the bank.  in 15 years, that's worth $464,000.

in 15 years the first loan with 25% down will now have a balance of only $577,000.  That's pretty good. Contrast that to the FHA secured loan.  At this point the mortgage insurance will be long gone, and at the end of 15 years, you still owe $727,000.

If you just looked at the two loans, and I said, “Would you rather owe $577,000 or $727,000,” of course $577,000 is $150,000 better.  That is until you subtract the estimated $464,000 sitting in the bank.  If you just took that money and applied it to your FHA mortgage, that $727,000 would come down to about $260,000.  Now, do you want to owe $260,000 or $577,000? The numbers swings way in the other direction with just a 4% average interest rate compounded annually.

Additionally, I think the 4% is probably too conservative. If you look at the stock market (granteding that on any given day or year it flutters), over a long period of time, and by long period I mean 30 to 40 year terms, the stock market, on average, has been returning 8.5%.  If you were to take that $258,000 dollars, stick it in the stock market and let that grow, and if you were lucky to get the stock market return of 8.5%, that $258,000 is going to grow into $877,000 in 15 years. You could just pay off your mortgage at that point. Plus, you have had easy access to those funds the entire time.

Benefits to Having Readily Available Cash Rather Than Having Your Cash Tied Up In Equity in Your Home

Often families have a need for cash.  If it's in your house, it is harder or sometimes very hard to get it. Having cash in more accessible investments not only allows you access to it for emergencies or college costs, but you might have another investment opportunity.  Maybe you want to buy another property, maybe buy into a business, or put money into and existing business. Your cheapest source of capital will be your own.

In other words, the analysis of which is a better deal shouldn't be solely based on which one is the lower monthly payment today.  In fact, if you don't mind doing a little extra stretch each month, based on this argument, you'd be better off paying the higher monthly payment of $7,800; and if you have to go to your bank every month and get $2,000 out of your cash reserve just to be equivalent to the $5,800, you could do that.  You're still going to be better off based on these numbers.

Equity in Your Home Provides You with 0% Rate of Return

Here is another related argument for not putting so much down if you don't have to. There are circumstances where you are required to put down 25%, or if it's an investment property, you might have to put down 25%.  Putting money into your principal feels good, is good.  That's the basis of a 30 year loan.  Every month you're forced to put money and it sits there.  At the end of 30 years, you have a nice windfall.  However, from a strictly financial point of view, putting money into your house is a “zero rate of return on your investment.”  Why is that? It sounds counter intuitive.

It's because putting money into your principal doesn't affect the value of your house.  Your house value is entirely derived by the marketplace.  I've never had a client yet, either buying his house or selling a house, that asks the owner of the current house, "How much do you owe on it?"  If the house is worth $612,000 because that's what the market is going to pay for it, it doesn't matter whether the owner of that house owes the bank potentially $612,000, or they owe the bank nothing because they own it outright.

In either instance they own that house.  Whether they put in zero and owe the bank $612,000, or they've been paying principal and they've worked it down so they owe less, the value of that house is $612,000 because that's what the market says.  From a strict definition, putting money into your principle is a zero rate of return, you'd be better off in this scenario taking your money in a CD, where at least it's going to earn something.

The Emotional Decision May Still Be Best For You

These are just numbers. It doesn't mean that anyone should necessarily follow what the numbers tell you to do, or that it's the best decision.  It's your money, and like anything else with your money, how you spend it should not just be with an eye on what's a wise or valuable way to spend it, but by what's making you happiest.  In this case, part of the happiness is tied to what's making you the most comfortable.

There is a huge value to the 30 year fixed loan.  It's not going to change.  If you're not someone who wants to have to read the paper every day and read about what's going on in a European country that

some bank run is happening in Cypress, and it could trigger X, Y, and Z; or there's issues in Congress over what's going to happen to the budget and taxes and deficits, then the 30 year fixed means that you don't have to pay attention to any of those things.  Your mortgage payment is not going to change, and you know where you're going to be today, next year, 10 years, and 30 years from now.

Paying a Little Bit More for Peace-of-Mind

So what the 30 year fixed is doing is buying you peace-of-mind.  I just want you to understand how these numbers work so you can choose what's going to make you happiest.  For many I talk to, having peace of mind is great.  They don't want to have to worry about what's happening in Europe. They can go on running their bike shop, or working in their restaurant, or working for Sony, and turn their back on outside issues roiling financial markets, because they've got a great deal and it's done. So even though they're paying a little more for the 30 year fixed than they might otherwise be able to with investments, that difference they're paying is basically paying for peace-of-mind.  And I think that's worth every penny.

If you would like help going through this analysis on your possible purchase or refinance, give me a call and we can look at all the options available.   310-295-6213   Bill Rayman
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