What Would You Do, If You Were Me?

Not very often, but every now and again, a client will ask me the following question: "What would you do if you were me?" It's a great question because, who better to ask than someone who is objectively aware of their income, assets, employment history and credit score as well as the various loan programs available. On the other hand, there are clients who, because they have bought and sold two or three homes in their lifetime, are convinced that they know every bit as much about home loans as I do, if not more. With them I just smile politely because almost no amount of reasoning is going to change their minds that there may be something better out there than what they construe to be the case.

First, let me state something that most people never think about: some home loans perform better than others because of the prevailing state of housing market. From 2003-2008, we had a rising housing market. In that market, price appreciation built up a borrower's equity very rapidly. As an example, in 2003, homes appreciated on average 38% in San Diego County. At the time, I said,

"Show me a borrower that increased their equity 38% in a year by making payments. In this kind of market borrowers provide little more than interim financing, while inflation and appreciation effectively pay down your mortgage."

With this kind of market I preached "that interest rates are largely irrelevant!"
Alas, such is no longer the case. As the saying goes, "That was then, this is now." Since 2008 we have had just the opposite with declining markets throughout most of the country. As home values depreciated interest rates became very relevant again particularly in cases of homeowners having negative amortization loans who were making minimum payments and not covering even the interest on their loans. For them, the past two or three years have been a major game changer and a disaster as they saw their loans recast with a higher interest rate, an increased balance, and one that recast as an amortizing loan with a shortened term.
Now, however, in San Diego, we are in a different market environment. The current market is essentially a flat one or one that is apt to experience only modest appreciation over the next five years.

Regardless of market conditions, most people opt for the safety and the security of a 30 yr. fixed rate loan and they pay dearly for it, usually a point to a point and a half higher in rate than with an Adjustable Rate Mortgage (ARM). 5/1 ARMs have been available for about the past 25 years and in the past two or three years I have had maybe 3 clients take me up on them. And some of those that had ARMs, refinanced into fixed rate products because they thought rates would be going up. Plain and simple, like most market timers, they were wrong.

Even though 30-yr. fixed rate mortgages (FRMs) sell at hefty premiums, they are overwhelmingly popular here. Thirty-year terms are not even available in most countries because they are too expensive. With a 30 year term, the interest costs roughly equal the loan amount because they are heavily front-loaded. This means that most of your payments in the early years go to pay for interest charges and comparatively little is applied toward principal reduction. In fact, it will be 20 years before most of one's monthly mortgage payment goes towards principal.

 Another reason for the popularity of 30-year terms is the home mortgage interest deduction. But it is increasingly hard to justify why homeowners should enjoy a preferential tax status over renters. Most developed countries do not allow a deduction for mortgage interest. And with our intractable budget deficits, the days of mortgage interest being deductible may be numbered.
Regardless, the goal should be to reduce the cost of owning a home. This is the key thing that borrowers fail to grasp, instead the majority focus on interest rate and affordability, when it should instead be about cost and principal reduction.

One loan that has been a great performer in all markets is the variable rate loan or adjustable rate mortgage because it "adjusts" to the prevailing market conditions. In rising markets, it becomes a little more expensive, but all things being equal it will still remain affordable. In declining markets, the interest rate also adjusts downward to reflect the market condition. In flat markets, rates tend to remain similarly flat.
In March, I did a 5/1 ARM for two PhDs. Not only were they highly educated, they were educable about their financing and willing to listen to reason, which enabled them to get an interest rate of 3.25% that is fixed for the next 5 years while 30 yr. fixed rate loans are currently at 4.5% or 1.5% higher. The reality (as I have stated ad nauseam) is that only 3% of homeowners will carry their 30 yr. fixed rate mortgage to completion. So, why pay a premium for something that 97% of you will never use. In California, just under half will refinance their home in less than 4 years to obtain a better interest rate, to get cash out, etc. And, by year 6 or 7, because we have a very movable population, most of them will no longer be living in that same home because they will have sold it and moved into a new (at least to them) home or down-sized it because "the kids are grown and out of the nest." So, for most of these borrowers they will have paid a premium of one to one and half points or more, for something that many of them will not utilize but for the first 4 or 5 years and that 90-some percent of them will not have beyond year 6 or 7.

Over the last several years, borrowers with adjustable-rate loans paid less as interest rates fell, while those with fixed rates kept paying the same amount for devalued homes. I put my stepfather into a 5/1 ARM about 8 years ago. It was fixed at 5.25% for 5 years. Beginning in year 6 it adjusted once a year downward. His margin, the component that is fixed for the life of the loan, of 2.25% coupled with the LIBOR index gives him an interest rate this year of a mere 3.01% because in November, when it adjusted, the 1-year index was 0.7614. (The 1 in a 5/1 ARM refers to how often it can adjust which is annually or once a year). For the past several years his rate steadily adjusted downward from 5.25 to 5.13, 3.34, to 3.01. In fact, if you took out any ARM in the last 5 years, your rate today is likely much lower. (Incidentally, I picked the 5/1 ARM because it had the best pricing of the ARM loans, then. It still has the "best bang for the buck" when compared with other variable rate products like the 3/1s, 7/1s and 10/1s which more nearly approach the 30 yr. fixed in pricing.

"An ARM? Are you crazy? What if rates totally skyrocket?" These are some of the most common objections to any ARM. Naturally, the question is usually rooted in a fear of the unknown coupled with a lack of the facts. For example, mortgage rates have only been above 7% for 23 of the past two hundred years. Still, some clients think that Carter-era rates are possible again. Doubtful. Those sky-high interest rates were caused by a lack of globalization coupled with economic shocks remember the Cold War? A large portion of the global economy was frozen behind the Iron Curtain. Shock waves such as those caused by the Arab oil embargos of the time had a much larger financial impact, since the playing field was much narrower and less connected. Now more countries are all competing on the global market, which is far more robust, minimizing the chance that domestic interest rates will skyrocket to those stratospheric levels.

Others tell me that ARM's caused the subprime meltdown. Wrong. The meltdown was caused by teaser rates, zero-down loans, high leverage, rating services with a conflict of interests and lax lending guidelines. Not by ARM's. Others think that inflation, leading to higher interest, is right around the corner. Driven by what? Tight labor markets and wage growth? Not with 9% unemployment. Depletion of inventories? Factories are idle, with plenty of inventory. We suffer from excess capacity and lack of demand. Meanwhile much of the rest of the world is still experiencing the recession from which we are recovering. The safe money still looks to U.S. Treasuries, and while all indications are that rates may edge upward slowly, the demand for safety (particularly given slow growth worldwide) will probably keep rates at historically low levels for years to come.

How fastwill rates go up, when that finally happens? When rates go up, will they
"skyrocket" as many people fear? Nope. When mortgage rates rise, they're typically a result of banks following monetary policy moves made by the Fed. Certainly, mortgage rates move with mortgage backed security pricing in the short term, but the market for mortgage-backed securities is absolutely connected to the larger debt market. Just graph the Fed Funds target rate against any of the major indices and you'll see the correlation (remember, some indexes lag, but they always correlate). The Fed only meets so often, and when they do, they only push rates up by 25 basis points (bps), and 50bps is rare. (Basis points are 1/100th of a percent). So the slopes on rising rate trends tend to look very similar. Look at the data and you'll see.

So, let's say one does get a 5/1 ARM and five years have gone by. Then what? Well, if interest rates continue to remain low I would keep the loan just as my stepfather did and enjoy the lower rates. But what if they had begun rising? Then I would say it would depend on how much they had begun to rise. I would then look to do one of two things. First, investigate replacing my ARM with another ARM (fixed for 5, 7 or 10 years depending on their pricing) and here is the important part SHORTENING the term to a 15 or 20 year term. Secondly, if I had enough equity (25%) I would consider the ultimate ARM.

The Home Ownership Accelerator (HOA) would be my first choice as a mortgage product if I were currently seeking a home loan on a primary residence. I mention the primary residence qualifier here because this loan program is only available for owner-occupied situations, no second homes or investment properties are allowed. This loan program is essentially a 1st position Home Equity Line of Credit. But, unlike most HELOCS, HOA loan amounts go up to $2.5 million.

At present, money in a checking account earns practically NO interest. With the Accelerator, however, your checking account is connected to your mortgage, so when you direct deposit your income into your checking account instead of earning no interest, the money is offsetting the 3.5% (base) interest rate on the HOA! Moreover, with a conventional mortgage loan a borrower pays interest before principal, but with the HOA, you pay principal BEFORE Interest. The HOA pays down the principal first and then calculates the interest on the reduced daily balance. This way, less interest accrues because of the reduced principal which in turn enables you to payoff the loan sooner. In fact, this simple reversal of procedure works so well that it negates much of the effect of compound interest such that you can retire a 30 year loan in about 16.4 years with no change to your spending habits.

Let me momentarily re-address the bogeyman of soaring interest rates since that is the concern I hear voiced most often: If you go back and look at the last 3 rising-rate trends for the 1-month LIBOR (the index for the Home Ownership Accelerator), dating back as far as the 1990's, there have been 3 rising rate periods (trough-to-peak), all with roughly the same upward slope. The average rate of increase in these 3 periods is +1.45% per year, or +12 basis points per month. The average duration of the last 3 rising rate trends is 26 months. So looking at history, the facts are that rates don't skyrocket. Instead, over the long run, they move up steadily following monetary policy. Even in aggressively-rising rate scenarios, because of its unique feature of paying principal first and interest second, it usually more than offsets the impact of rate increases.

The Home Ownership Accelerator is a variable rate mortgage that is tied to the 1-month LIBOR (London Interbank Offered Rate). With the HOA, one has a choice of 3 margins: 2.85%, 3.1% or 3.35%. The 1-month LIBOR is currently 0.261%. So, depending on the margin chosen the FULLY-INDEXED RATE could be as little as 3.111%, 3.361% or 3.611%. Note: there is 3.5% FLOOR RATE which means that one's payment will always be at least 3.5%. The maximum Debt-To-Income (DTI) ratio is 45%, but one is allowed to qualify at the interest only rate. The lifetime cap is 6% over the starting rate. Thus, one's interest rate in a worst case scenario could never exceed 9.611% and history has shown that rates of 7% and above have existed for only 23 years over the past two centuries.

Another drawback of the conventional 30 yr. mortgage that receives scant attention is that it's inflexible. With a conventional mortgage, when you make that payment, it is gone forever. The HOA is flexible and reversible, so if the need arises (because of
emergencies or for financial opportunities) you can access to equity. You have 2-way access to your available equity 24/7 for a full 30 years. For your everyday expenses you have unlimited checks, an ATM/Visa Point-Of-Sale card and electronic (bill-pay) access to your funds, just like a regular bank account. The HOA provides an initial credit line for 10 years and during the final 20 years it decreases the credit line by 1/240th per month.

Another facet of the HOA is its convenience: It's the only loan where you don't have to write a check to make your payment. If you have available credit, the payment is made automatically on the payment due date. This also avoids accidental late payments. The only requirement that one has is to stay below their credit limit.

Some people are concerned that with all of this interest being saved, their tax deduction will go down. Believe me, if this is bad news, you can afford to live with it because you pay about $3 in interest to get a $1 deduction. If you don't understand the obvious fallacy inherent in this, then the answer is easy: if you want a larger tax deduction, get a loan with a higher rate!

So, if I was looking to finance a purchase money loan or to refinance an existing mortgage, I would go with a 5/1 ARM loan. With subsequent refis I would opt for a mortgage with a shorter term say 15 or 20 years. If it were my primary residence and I had 25% for a down payment or existing equity in the property, I would definitely go with the HOA.

Copyright 2020 Rod Haase.  All rights reserved.