Shorter may be better…

Benefits of 15-year mortgage hard to beat

Why those lured by smaller payments on 30-year loan should reconsider

Jack Guttentag, Inman News,  April 30, 2012, link

<a href="" target=blank>Cash and real estate image</a> via Shutterstock.Cash and real estate image via Shutterstock.

The case for 15-year fixed-rate mortgages has never been stronger because, in the post-crisis market, the rate advantage over the 30-year has never been larger. The rate advantage is about 0.875 percent, whereas prior to the crisis, it was 0.375 percent to 0.5 percent.

Consider two $100,000 loans, one a 15-year at 3.125 percent and the other a 30-year at 4 percent. The respective payments are $696.61 and 477.42. After 15 years, the borrower with the 15-year loan has paid $39,454 more but is out of debt whereas the borrower with the 30-year loan still owes $64,543.

But there is a counterargument. A disciplined borrower can choose the 30-year loan and invest the difference in payment between the 30- and the 15-year loans, in that way offsetting the higher interest rate on the 30-year loan. Some financial planners recommend this approach to their clients as part of a program to build wealth faster.

The challenge in making such a program work is that the rate of return on the invested cash flow must exceed the rate on the 30-year loan by an amount that depends on how much higher the 30-year rate is than the 15-year rate.

For example, in 2006 when I first looked into this issue, I used rates of 6 percent and 5.625 percent on the 30- and 15-year loans. I found that over a 15-year period, the cash flow savings had to yield 7 percent, or 1 percent more than the rate on the 30-year loan, to just offset the higher interest rate on the 30-year loan. This can be termed the break-even return on the cash flows. To come out ahead, the borrower has to earn a return above the break-even return.

I recently repeated the exercise using rates of 4 percent on the 30-year loan and 3.125 percent on the 15-year. With these rates, the break-even return is 6.15 percent, or 2.15 percent higher than the rate on the 30-year loan. The larger rate spread between the 15- and 30-year loans increases the difficulty of developing a profitable reinvestment strategy.

The challenge looms even larger if the borrower holds the mortgage for less than the 15 years I assumed. The break-even rate is higher over shorter periods because the difference in the rate at which the 15- and the 30-year loans pay down the balance is largest at the outset and declines over time. The shorter the period, the higher the reinvestment rate must be to offset the larger difference in balance reduction.

Average mortgage life today is somewhere between five and 10 years. At 10 years the break-even rate rises to 8.02 percent, and at five years, it jumps to 13.69 percent — a whopping 9.69 percent above the rate on the 30-year loan.

These calculations assume that the borrower makes a down payment of 20 percent or more. If the down payment is less than 20 percent, the borrower must pay for mortgage insurance, and the premiums are higher on the 30-year loan.

For example, if you put down 5 percent and pay standard insurance premiums, the break-even rate rises from 6.15 percent to 7.01 percent over 15 years, from 8.02 percent to 9.56 percent over 10 years, and from 13.69 percent to 16.88 percent over five years. Note: All the break-even rates shown above are derived from calculator 15b on my website.

These required returns are forbiddingly high for any borrower who would invest the cash flow savings by acquiring financial assets. There is no way a borrower can earn such returns without taking very large risks. Most borrowers probably fall into this category.

But there are some borrowers for whom the cash flow reinvestment strategy might make sense. One is the borrower who is eligible for but not currently utilizing IRA, 401(k) or other qualified tax-deductible or tax-deferred plans. Borrowers who use their cash flow savings to invest in these vehicles, who would not do so otherwise, can earn a very high rate of return because of the tax benefits. If the borrower’s employer makes matching contributions, the return is even higher.

A second category of borrowers who can earn a very high rate of return are those with high-cost debt. A borrower paying 18 percent on credit card balances earns a return of 18 percent by paying down the balances.

In my 2006 article on this topic, I argued that borrowers who have not fully exploited all tax-advantaged investments, or who have high-rate credit card balances, are unlikely to have the iron discipline required to invest the cash flow savings on their mortgage month after month. But the financial planners who wrote me argued that they have developed special plans for borrowers in such situations that provide the discipline that is required. But until I see such plans along with evidence that they work, I will remain skeptical.

Reversing attitudes on reverse mortgages…

Reverse mortgage not just a ‘last resort’

How blending product with other investments can boost retirement income

By Tom Kelly, Inman News, Wednesday, April 18, 2012, link

<a href="" target=blank>Money image</a> via Shutterstock.Money image via Shutterstock.

The number of Americans 65 and older who continue to work  has risen in the past decade. The unexpected rise can be traced to a variety of  factors, including shell-shocked retirement accounts, falling interest rates on  savings tools, fewer company pension plans, and the inability to save.Many of these people have raced to take part-time  employment, and baseball spring-training facilities are a prime example. There  were seniors selling tickets, programs, hot dogs and popcorn, plus acting as  ushers and parking lot directors in nearly all of the recently completed Cactus  and Grapefruit League games.

The goal of this age cohort is to supplement their Social  Security payments and portfolio securities (such as 401(k) and individual  retirement accounts) so that they won’t run out of money before they die. What  other sources might be available?

Barry H. Sachs, a real estate tax attorney in San Francisco, and Stephen R. Sachs, professor emeritus in  economics at the University   of Connecticut,  researched ways to further enhance a senior’s finances by adding home equity  via a reverse mortgage. In a recently published study, the authors found that a  reverse mortgage can be powerful tool when used within a coordinated strategy  rather than a “last resort” after exhausting the securities  portfolio.

The model shows that the retiree’s residual net worth  (portfolio plus home equity) after 30 years is about twice as likely to be  greater when an active strategy is used than when a conventional strategy is  used.

“It’s so important that financial planners have begun  to ask the question about what’s possible with reverse mortgages,” said  Martin J. Taylor, president of Bellevue, Wash.-based Stay In-Home, a reverse  mortgage lender. “While they have often been known for solving desperate  situations, they have a variety of uses in long-term financial planning.”

What Sachs and Sachs have done is to compare three  strategies for the use of home equity via a reverse mortgage to increase the  safe maximum initial rate of retirement income withdrawals. The commonly  accepted “safemax” begins with a first year’s withdrawal equal to  4-4.25 percent of the initial portfolio value. Subsequent years’ withdrawals  then continue at the same dollar amount each year, adjusted only for inflation.  Since many retirees have found the safemax uncomfortably limiting, Sachs and  Sachs calculated greater percentages in some examples.

The strategies:

(1) The conventional, passive strategy of using the reverse  mortgage as a last resort after exhausting the securities portfolio.

(2) A coordinated strategy under which the credit line is  drawn upon according to a formula designed to maximize portfolio recovery after  negative investment returns.

(3) Drawing upon the reverse mortgage credit line first,  until exhausted.

The authors found “substantial increases” in the  cash flow survival probability when the active strategies are used as compared  with the results when the conventional strategy is used. For example, the  30-year cash flow survival probability for an initial withdrawal rate of 6  percent is only 55 percent when the conventional strategy is used, but is close  to 90 percent when the coordinated strategy is used.

So, how is the reverse mortgage best blended together with  other investments? In a nutshell, it’s a basic algorithm:

At the end of each year, the investment performance of the  account during that year is determined. If the performance was positive, the  next year’s income withdrawal is from the account. If the performance was  negative, the next year’s income withdrawal is from the reverse mortgage credit  line.

According to the study, this spares the account any drain  when it is down because of its investment performance. It also leaves the  account more assets to recover in subsequent up years. This is done in the  early years of retirement, so the account grows before the reverse mortgage  credit line is exhausted.

The authors emphasize that a reverse mortgage is not  necessarily a useful vehicle for every retiree who has substantial home equity.  A retiree whose primary source of retirement income is a securities portfolio  and who also has substantial home equity must decide early in retirement  whether to live within the safemax limit set by his or her portfolio. This  decision is a fundamental component of overall retirement planning.

Watchdogs are watching your interests…

US watchdog targets discriminatory lending

By Reuters, April 18, 2012, link

The new U.S. consumer financial watchdog said on Wednesday it will aggressively pursue discriminatory lending practices, including those that may not be intentional but wind up penalizing minorities or women.

The Consumer Financial Protection Bureau on Wednesday sent a notice to banks and other lenders emphasizing that enforcing anti-discrimination laws is a priority.

The agency has also drawn up a tip sheet to help borrowers determine if they are being discriminated against that will be posted on its website.

“Our economy is in the process of recovering from the worst financial crisis since the Great Depression,” CFPB Director Richard Cordray said in remarks prepared for a speech to the National Community Reinvestment Coalition, which focuses on lending discrimination. “We cannot afford to tolerate practices that either price out or cut off segments of the population – such as women, the elderly, or communities of color – from the credit markets.”

The agency emphasized that it views discrimination as going beyond practices that are obviously designed to treat minorities and women differently.

If a lending policy over time results in any group being treated differently, even if that is not the intent, the agency will crack down on the lender, Cordray said.

“It is important to recognize that this subtle but powerful form of discrimination creates damages that are no less direct than the kind of overt and blatant discrimination that, we hope and assume, is increasingly a relic of a bygone era,” he said.

As an example Cordray offered a scenario in which lending officers have wide discretion to determine interest rates and fees for borrowers, resulting in minority groups or women being charged more.

The agency, which was created by the 2010 Dodd-Frank law to police lending products like credit cards and mortgages, also said it would pursue practices that result in a lower availability of loan products for minorities or women.

The agency has been heralded by supporters as an antidote to the lending abuses that occurred in the run up to the 2007-2009 financial crisis.

Banks have been wary of the new watchdog, warning that too many restrictions will constrain lending and prevent many consumers from being able to get loans for buying a home or other products.

Cordray on Wednesday again emphasized his point that the agency can help banks through its power to oversee competing lenders that had not previously been overseen by a federal regulator.

“The bureau will be supervising these entities in a tough but fair manner to single out the silent pickpocket and stop discrimination in its tracks,” he said.