This piece arrives at an interesting junction. The property and credit markets remain frozen, Wall Street operates well within the throes of a gruesome bear market, and job losses have exceeded the depths of the 2001 recession. Counter intuitively the environment is ideal to speak upon mortgages.
1: Today’s informed buyer must avoid the mistakes that precipitated this housing bust.
2: Foreclosed properties and desperate sellers present extraordinary bargains.
3: Washington legislation and fiscal policy have effectively lowered mortgage rates.
Let us present the basic terms, conditions, and relevant commentary concerning these instruments – assuming nothing.
Mortgage Defined
The home mortgage is a loan issued towards the purchaser of the property. Technically, the bank owns the structure until the buyer has remitted all payments and satisfied the loan. Often, the monthly payment is divided into principal, interest charges, and the escrow account.
Payments are usually due monthly, and a breech of the mortgage contract will ultimately result in foreclosure. The bank seizes the property at this point – seeking to auction off the home in an effort to recoup losses.
The mortgage is a critical cog of the financial system. Few individuals maintain the hundreds of thousands of dollars necessary to purchase housing in cash. Real Estate and the economy at-large would shut down without the proper access to credit. Credit is the lubrication that allows for the basic functioning of the financial system that is the mark of any organized society.
The credit markets and money center banks must be stabilized at all costs.
Principal and Interest
The principal is the amount of the loan that is yet to be paid off. Interest payments compensate the financial intermediary, or bank for assuming the risk of lending money. Greater risks carry higher interest charges.
The banking industry led by government-sponsored enterprises [g.s.e.] Federal National Mortgage Association [Fannie Mae] and Federal Home Loan Mortgage Corporation [Freddie Mac] pools mortgages, organizes them into tranches according to risk, and sells them off to investors. The strategy is referred to as securitization and is a means designed to spread risk throughout the financial system.
The housing bust and economic debacle has left Fannie and Freddie as the lone major participant within the mortgage securitization market. These entities are critical aids to home ownership by managing risk and effectively lowering interest rates.
Interest payments often amount to hundreds of thousands of dollars over the life span of a mortgage. Every percentage point is critical on any 15 – 30 year loan.
Several mortgage products feature interest only payments. We highly advise against the utilization of these instruments.
Escrow
The escrow account captures portions of the mortgage payments and allocates the funds to be disbursed to meet property taxes and private mortgage insurance (P.M.I) at a later date.
The escrow account is a necessary evil. First, escrow payments do nothing in terms of directly creating value. Secondly, the borrower receives no interest courtesy of the account. Lastly, the homeowner must actually pay for the insurance that protects the bank from his very own default on the loan.
Good Times!
Equity
Equity represents the dollar value of the property that is actually ‘owned’ by the individual. For example, Mr. Buyer purchases a $300,000 home with no money down. Mr. Buyer then pays off $15,000 worth of principal in two years. At that point, the real estate market has corrected, and his residence is now valued at $325,000. Mr. Buyer’s home equity is now calculated at $40,000. ($325,000 value – $300,000 purchase price – $15,000 in principal payments).
The homeowner can ‘mortgage’ the property – borrowing against this asset in the form of a home equity loan.
Millions of consumers mistakenly believed that property values would continue to rise and proceeded to borrow against home equity. Instead, the boom went bust and these citizens are now trapped within homes in which they owe more money upon than the plot is actually worth. This discouraging predicament has led to increased foreclosure. The exasperated consumer is unlikely to commit to timely payments upon a $400,000 loan connected to a homestead that has actually plunged in value to $250,000.
Basis Point
.01% = 1 Basis Point.
Jumbo Mortgage
The purchase is backed by a loan amount larger than $417,000. Jumbos are not securitized by the government-sponsored entities Fannie and Freddie. Jumbo mortgage interest rates are typically 100 – 200 basis points, or 1-2% higher than loans of comparable terms.
30 Year Fixed Mortgage
The standard, plain vanilla loan backing real estate purchases. The buyer is set to pay off the loan in thirty years at a fixed rate of interest for the life of the mortgage. We highly recommend the basic thirty-year fixed mortgage as the preferred instrument of all real estate transactions.
15 Year Fixed Mortgage
The terms mirror those of the thirty-year with a fixed rate of interest over the term. Of course, consumers must repay the liability within fifteen years, rather than thirty. Interest rates are typically several basis points lower on the 15-year mortgage in comparison to the 30. As of Wednesday, November 26th prevailing 30-year mortgage rates average 6.08%, while the 15-year mortgage is a scant lower at 5.81% according to Bankrate.com.
Fifteen-year mortgage holders will save thousands of dollars in interest payments over the course of the loan. Let us present the numbers.
A $250,000 30-year fixed mortgage at 6.08% will carry interest charges of $294,233 over the lifetime of the loan. The monthly principal and interest payment is $1,512. (NOTE: $1,512 figure does not include taxes or p.m.i. Expect a $2,000 mortgage payment on this loan)
The $250,000 15-year fixed mortgage at 5.81% carries interest charges of only $125,132 over the fifteen years – savings of $169,101. The caveat: monthly principal and interest payments increase to $2,084 – approximately $2,600 for the total mortgage with property taxes.
The paper arithmetic favors the fifteen-year mortgage. However, the selection must be executed according to the buyer’s cash flow requirements and risk tolerance. Perhaps the homeowner is unable to afford the increased payments of the 15-year. Perhaps the buyer would prefer to leverage the thirty-year loan, freeing up cash to allocate towards outside investments that will construct a grubstake over the thirty years that will trump the $169,101 savings.
For example, the $500 monthly payment savings garnered by selecting a thirty-year loan over the fifteen-year invested at 11% (average stock market return) equates to a future value of $229,428.78. The execution of said strategy outperforms the fifteen-year model by $60,328.
Adjustable Rate Mortgage
The adjustable rate mortgage features a low introductory ‘teaser’ rate for a set period of time. This initial period may range from one month to five years or more. Upon the expiration of this period the interest rate ‘adjusts’ in line to a predetermined index and algorithm calculated by the lender. Treasury securities and the London Interbank Offered Rate [LIBOR] often serve as benchmarks for the adjustment.
The adjustable rate mortgage arrived as a tool designated for real estate investors and short term residents to minimize cash payments towards the property before selling out at a profit. The ARM, originating as an ideal instrument for the sophisticated investor degenerated towards a distorted and exploited product, symbolic of the housing bust.
Mortgage brokers peddled adjustable rate mortgages to happy-go-lucky consumers as a means to capture unrealistic lifestyles. The Pitch: mortgage payments upon this grandiose estate are now within the means of Joe Six-Pack amidst the introductory 5-year teaser rate period. Never mind that payments may skyrocket by 60% upon the expiration of these five years. We can either sell the property to the highest bidder at a profit or refinance into yet another ARM. Right?
Dead Wrong.
Real estate has been felled by outright collapse and the credit market is theoretically paralyzed. Joe America, previously living high on the hog is unable to sell out at a premium to repay the loan. Also, the sub-prime borrower cannot refinance amidst today’s credit debacle.
This example of the living-dead is doomed to foreclosure.
Conclusions
Although we recognize the prevalence of cheap real estate, we strongly caution readers to avoid the very same gaffes that precipitated today’s economic calamity. The housing bust proves that real estate investment is far from the silver bullet wealth builder that proponents have billed the sector to be. Irrespective of housing prices, interest charges are indeed staggering and must be included within any calculations of total return. The property market barely outperforms the rate of global inflation over the long term.
