Tactical Execution

If you were to rate every possible loan program on a scale from the most conservative to the least conservative, you’d have the 30-year and 40-year fixed amortizing loans on the conservative end and the negative amortization variable-rate loans on the opposite side. Those are the two extremes.

On the conservative end, you’re paying off the loan at a fixed interest rate. Nothing changes. Your payment is exactly the same each and every month, for 30 or 40 years. That means you make the exact same payment today as you will in the year 2037, or even 2047. Nothing ever changes. Inflation will continue. You will probably get raises at your job. But your mortgage payment will always be the same. So, presumably, your mortgage payment should become easier and easier to make as the years go by.

On the aggressive end, you’ve got a loan where your payment isn’t even enough to pay the interest on the loan! So the size of the loan actually gets bigger each and every month. To make matters worse, the underlying interest rate is usually variable. That means you can’t even plan the extent to which your loan balance is expected to grow.

We’ll take a look at the whole spectrum but first, we need to examine the interest rate structure. The 30-year fixed mortgage is one of the most conservative options available. It has the least amount of risk. Well, for the bank, the opposite is true. By reducing risk for the borrower, all the market risk is transferred to the bank. If interest rates sky-rocket, the bank cannot change the rate on your mortgage. It’s fixed. They also can’t “call” the loan because you’ve got a full 30 years to pay it off. So the bank could be making more money by lending to someone else but they’re stuck with you and your low fixed-rate mortgage.

That’s a risk the bank takes when it gives you a fixed-rate mortgage. And as a result, the bank charges a premium for 30 or 40-year fixed mortgages. In fact, all other things being equal, interest rates get higher when you fix them for a longer period of time. An interest rate that’s fixed for 5 years will be slightly higher than one that’s fixed for only 3 years. A 7-year fixed is higher than a 5-year fixed. A 10-year is higher than a 7. A 15-year is yet higher and a 30-year fixed interest rate has traditionally been the highest. Of course, recently, the lending community has come out with the new 40-year mortgages. When fixed for the full 40 years, the rate is slightly higher than the 30-year. You pay for the luxury of a fixed interest rate; the longer it’s fixed, the higher the rate is.

Remember: “all other things being equal.” That’s what we’re talking about here. Given the exact same credit, income and assets; given the exact same closing cost structure; given the same down payment or equity; the interest rate will be higher as you fix it for a longer period of time. There’s no question that rates could be higher or lower if other things in the file are different. For example, if you’re comparing a 2-year fixed Subprime loan to a 5-year fixed A-paper loan, the 5-year fixed would undoubtedly have a lower rate than the 2-year Subprime but then again, there are big differences between A-paper and Subprime loans.

It’s also worth noting that the extent of these differences varies depending on market conditions. In the financial world, they refer to this as the “yield curve” and some times it’s pretty steep and other times, it flattens out. Essentially, the curve shows how big the difference is between the 30-year fixed and, say, a 1-year fixed. And again, sometimes the difference is pretty big and other times, it’s very small. In fact, sometimes, the curve can even be inverted where the rates for short-term borrowing can actually be higher than the rates for long-term borrowing. Generally speaking, these situations are rare and we won’t spend any more time on them here.

The point is that the 30-year fixed is, historically, the most conservative choice. You pay for that security with a slightly higher interest rate but the risk is extremely low. The new 40-year mortgage is now increasingly common and by amortizing the loan balance over a longer period, it allows for slightly lower monthly payments. Both of these loans have traditionally required “amortizing” payments; that is, they include both principle and interest.

Recently, the option of a 10-year (or even 15-year) Interest Only period has been introduced to the 30-year fixed product. The rate remains fixed for a full 30 years but you only have to pay interest for the first 10 or 15. If you think about it, there’s no reason to have a 40-year loan if you also select the Interest Only option. If you’re only paying interest, the amortization period becomes irrelevant. Either way, you’re only paying interest. The difference would show up after the Interest Only period expires. With a 30-year loan, the remaining amortization period would be squeezed into the last 20 or even 15 years, meaning the payment would jump up significantly at that point. With a 40-year loan and a 10-year Interest Only period, you’d still have a full 30 years to pay the principle down. Yes, the payment would jump up in that scenario as well but not by as much.

Now, how many of us actually plan to spend the next 30 or 40 years in the same house? Perhaps some of us do but the majority plan to move into a different place sometime before 2037 (30 years from now). In a normal “yield curve” market, the trick is to balance the fixed period with the length of time you intend to stay in the property. There’s no sense paying a premium to fix the interest rate for a period of time when you’ll no longer have the mortgage. There’s no sense paying for a luxury you’ll never benefit from.

In today’s marketplace, you can fix an interest rate for 6 months, 1 year, 2 years, 3, 5, 7, 10 years, 15, 20, 30 and even 40 years. So take a minute and think about how long you intend to stay in your current property. 5 years? Maybe 7? If that’s the case, you should only fix your interest rate for 5 or 7 years; maybe 10, just to be safe. That way, you’ll get the lowest interest rate possible while still getting the security of a fixed interest rate for the period of time you expect to keep the mortgage.

Most of these loans – the ones that are only fixed for 3, 5, 7 or 10 years – still have a full 30-year term. The payment is still calculated as if it was a 30-year amortizing loan. Again, if you select an Interest Only option, the amortization schedule becomes irrelevant. It doesn’t matter; you’re only paying interest anyway, at least until the fixed period expires. But for an amortizing loan, the payment is based on a 30-year amortization period and is completely fixed during the initial fixed period. After that, the rate changes to an index plus a margin and the loan becomes variable. The margin never changes but the index can move up or down depending on trading activity in the bond markets and what the Fed is doing.

So, in what circumstances should you select an Interest Only mortgage? Many homeowners today are stretching to make their monthly mortgage payments. Home prices have risen much faster than salaries, so it’s a bigger strain on homebuyers than it was years ago. If you select an amortizing mortgage, you’re basically putting yourself into a forced savings program. Any money you put towards your principle increases your equity. You get all that money back when you sell the house because your loan balance will be lower than it would otherwise, leaving you with more equity. An amortizing mortgage is definitely the ‘conservative’ choice.

On the other hand, you can look at an amortization schedule and see how much of the principle you actually pay down during the first 5 years of a 30-year mortgage and it isn’t much. If you’re only planning to stay in the property for 5 years, the difference in your equity is fairly minimal. Meanwhile, paying interest only would reduce your monthly payment. In California, Interest Only mortgages are extremely common and they definitely serve a purpose for those homeowners who are planning to get into a new, perhaps bigger, property within a few years.

The important thing to remember, obviously, is that your original principle balance never gets any smaller. No, with an Interest Only mortgage, you’re basically renting the house and relying on appreciation to build equity. During the past 25 years with house prices rising pretty consistently, this strategy has paid-off handsomely. But what happens when the market starts going sideways as it is today? What happens if prices remain the same or even go down a bit?

Also, consider the fact that you’ll have to pay 5 or 6% real estate commissions when you sell. If you put 20% down on a house and only pay interest for 5 years and if house prices remain stable, you’ll actually lose money on the deal. You’ll start with 20% equity. If you end up paying 5% real estate commissions, you’ll sell the place with only 15% equity (20%-5%) so you’ll have less money after you sell the place than when you bought it 5 years earlier. And that doesn’t include the closing costs associated with the original purchase. Those generally run about 2% so you’d end up losing 7% of the house’s value during the 5-year period.

If the place actually drops in value, the situation gets even worse. I recently spoke with someone in this situation. He bought a place 10 months ago and can’t keep up with the mortgage payments. His situation is even worse because he’s got a prepayment penalty in his loan. Meanwhile, his home hasn’t appreciated a cent. Between real estate commissions and the penalty, he’ll be out over $35K if he sold today (he originally did 100% financing). If he rents it out, he’ll still be under water about $1500 per month. Either way, he’s in a bad situation. You have to be careful. No matter what anyone tells you, profit is NOT guaranteed.

Now, in fairness, I have to say there are some “deficiency” laws that protect people in these situations. Depending on the circumstances, the lender may NOT be able to go after the homeowner for the deficiency between the sales price and the balance on the mortgage. But no one should rely on that when buying a piece of property. Fact is; there are real risks in the real estate market and you should be cautious about buying property, particularly if you plan to do 100% financing.

Okay, here’s a great little strategy that can significantly reduce your principle balance, EVEN if you’re on an Interest Only program. Most people who own their house end up getting a huge tax refund check every year – sometimes $10K or more. If you have the discipline, take that money and put it towards the principle balance on your mortgage. If you did that religiously every April, you would end up making a lot more progress on your principle that if you just had a regular amortizing loan. Yes, it takes discipline. But if you can manage it, you end up with the lower monthly payments AND a lower mortgage balance at the same time.

All right. Let’s get back to the discussion about fixing interest rates. As I mentioned, you can fix the rate for 30 or 40 years; the entire life of the loan. Or you could fix the rate for a shorter period of time like 5 or 7 years. Well, you can also select a variable rate program that’s not fixed at all. Home Equity Lines of Credit are examples of variable rate products. They’re variable right from the start. You can also get a traditional mortgage that’s only fixed for 1 month and then the interest rate becomes variable. Be careful with these loans because things can get scary if rates start rising and your monthly payment starts getting out of reach.

And that brings me to the last major loan program; one that has been incredibly popular in recent years – and it’s one of the biggest reasons behind the mortgage meltdown, by the way. These programs are scary because they’re the least conservative of the bunch – and most people who have these mortgages have absolutely no idea how they really work. They’re called Option ARM loans and they give borrowers a choice of 4 different payment options each month. If they choose, they can pay a minimum payment which is based on an artificial starting interest rate of just 1%. They can also pay the Interest Only payment. They can pay the 30-year amortized payment or they can pay the 15-year amortized payment – the highest of the 4.

We’ve all heard about these 1% mortgages. They’re heavily promoted and most of the marketing is deceptive. I personally believe that less than 10% of the people who get into these loans truly understand what they’re getting into. There’s no research to support that – it’s only my opinion – but it wouldn’t surprise me. Let’s take a closer look and unravel the hype surrounding these loan products. Believe me; they’re not as great as they may appear.

First off, rates have never been 1% and they never will be. 1% is a marketing label that helps sell loans. They calculate the payment assuming a 1% start rate, but this minimum payment is less than the Interest Only payment. You’re under water right from the start. The difference between this minimum payment and the Interest Only payment is referred to as “deferred interest” and it gets added to your mortgage balance each month. It’s called Negative Amortization and it erases your equity every time you make that low minimum payment.

Secondly, these loan programs are rarely fixed. They’re variable right from the first month. The minimum payment structure is indeed fixed for the first 7 years (in most cases), but that’s an artificial payment – a Negative Amortization payment. Those minimum payments don’t reflect the true interest rate at all. The underlying interest rate on these loans is variable and can change every month.

Third, the 30-year amortized payment is not fixed either. When people hear “30-year”, they automatically assume “fixed”. That’s not the case here. There’s a big difference between “amortized” and “fixed”. With a variable interest rate, the 30-year amortized payment changes each month. And these days, it’s probably getting higher, not lower.

I have to admit that there is real value in these programs for people who fully understand them. In an appreciating real estate market, these programs can make it easier to maintain an investment property at a cash-neutral or cash-positive level. They can also provide flexibility for people with uneven income streams. But if the real estate market is not appreciating, these programs erase your equity and destroy potential profits. Educate yourself before signing up for one of these programs.

So that gives you an overview of the programs available. Of course, there are countless details that can vary from one program to the next but this discussion definitely outlines the four basic categories: permanently fixed, temporarily fixed, variable rate and the negative amortization loans. And my personal advice: when in doubt, go conservative.