Alternatives to Large Down Payments

By Barry Habib
Contributing Editor to CNBC.com

The good news is you have many mortgage options. That's also the bad news. 

Selecting a mortgage is one of the biggest financial decisions an individual or family can make. So it's crucial to see how your choice affects your total financial picture. Too many borrowers shop just for the lowest rate. The Internet has further turned mortgages into a commodity. The lowest rate on the wrong program is far more costly than a competitive rate on the program that best suits your needs.

Rates are important, but you also need to consider a host of other variables, including taxes, term, fixed vs. adjustable, rate locks and, perhaps most importantly, the loan amount.

The size of the loan is perhaps the most frequently neglected question. Buyers commonly shy away from larger mortgages because they don't understand the alternative uses of their money. Most people fear debt, sometimes to a fault.

Homebuyers often have better alternatives for their money than putting it toward the purchase of a house merely to cut the size of their mortgage. For example, many relatively safe tax-exempt bond funds pay a better after-tax return than you would get from paying down your mortgage.

A family in the 28 percent tax bracket actually earns 9.44 percent (after taxes are figured) on a municipal bond fund paying 6.8 percent. So at mortgage rates below 9.44 percent, you should take out the biggest mortgage possible.

Home prices have escalated in recent years. Many homeowners find themselves with relatively small mortgages relative to the market value of their homes.

An example here helps bring the point home.

You buy a home valued at $250,000. You can afford to put $150,000 down. That leaves you with a $100,000 mortgage at say 7.5 percent. You could also put $50,000 down and take out a $200,000 mortgage.

You could take that $100,000 of free cash and put it into a municipal bond fund yielding 6.8 percent. You’ll probably end up making more that way in the long run.

Look at it this way; the borrowed $100,000 would cost 7.5 percent minus the tax deduction (let's say 28 percent) of 2.1 percent, netting the cost out to 5.4 percent. The difference between the two options (6.8 percent municipal bond and 5.4 percent net cost on the mortgage) is 1.4 percent.

The savings on $100,000 would be $1,400 per year. The higher the tax bracket the greater the savings. Be careful not to borrow more than 80 percent of the value of your home or you will probably need to pay a monthly private mortgage insurance premium that would negate the savings. The mortgage tax deduction ends at $1 million for first mortgage liens on primary residences. The tax deduction for second liens is capped at $100,000. Mortgage rates can be slightly higher for “jumbo” loan amounts; that is, loans over $300,700. This is the new limit for "Jumbo" loan amounts.

Many other alternatives can be worthwhile. Paying off higher rate or non-deductible debt can save a lot of money. Individuals who have chosen more aggressive though riskier approaches have found them to be very profitable.

The S&P 500 stock index has averaged a return of about 15 percent per year for the past four years. After a capital gains bite, the net percentage earned after tax would be 12 percent. This is a much greater return than the 5.4 percent net cost of borrowing on your mortgage. In fact, the S&P 500 has averaged a greater than 15% return for the past 30years. That means your money should double every five years. This can have a dramatic effect over time. Let’s look at a couple of examples:

I see so many people using a home loan refinance to save money by lowering their monthly payment. That’s great, but the monthly savings is often spent frivolously and not used for a long term, meaningful investment like college or retirement. Think about keeping your payments the same but borrowing a higher amount. So if you owe $200,000 and are saving $200 monthly by refinancing, you could borrow $230,000 and keep the same payment. That $30,000 could be used to invest for your child's college education. Based upon historic rates of return for the S&P 500, that $30,000 investment would be worth $240,000 in 15 years. That’s a great way to save for college.

A mortgage is typically the largest single financial move people make and should be the centerpiece of any good financial plan. Use it to create wealth for yourself. Let’s say you planned to take out a loan of $200,000 on a home worth $350,000. If you instead make a down payment of just $100,000, you can invest the extra $50,000. At an historic rate of return of 15% annually, that $50,000 investment would be worth around $400,000 in 15years. That's enough to pay off the mortgage completely in half the time and give yourself a bonus of $215,000. Now that's a nice way to reach your retirement goals.

A mortgage can be a great financial tool. It should not be obtained the same way you buy a book online. Consult your mortgage professional, tax specialist or financial planner. It's your money.

APR Can Cost You

By Barry Habib
Contributing Editor to CNBC.com

A borrower who is shopping for the best mortgage rate can easily be seduced by low rate offers that are accompanied by low Annual Percentage Rates (APR). Federal Law requires that APR be disclosed along side the actual interest rate…this is in order to help borrowers make a more informed decision on their mortgage. The truth is that APR is a very poor way to comparison shop for a mortgage and can cause borrowers to make costly wrong decisions.

APR was created in order to provide a way for borrowers to account for costs associated with the mortgage. This sounds good because it may not be very easy to choose between a loan with a lower rate and higher fees or a loan at a higher rate and low fees. The problem is that the APR calculation makes some very bad assumptions. First, APR assumes zero inflation and that the value or buying power of a Dollar today will be exactly equal to the value of a Dollar 10, 20 even 30 years from now. Next, the APR calculation assumes that the mortgage will never be prepaid or paid off. That means no refinancing or selling the home…highly unlikely since the average life of a home mortgage loan is less than four years. Just think, about your own clients. Is it not rare to see the same loan in place for even 5-years…forget 30-years. The APR calculation does not consider the value of the money used for fees. So if you spent thousands of dollars in points or fees to get a lower rate, the APR calculation does not give any value to the money if it were not spent on closing costs. Finally, APR does not take tax consequences into consideration. This can be significant since higher fees on the mortgage may not be deductible while the higher interest rate typically is deductible. Moreover, APR can be manipulated, making it totally worthless.

So how does APR work anyway? I like to explain it to my clients by using triangles. I often draw two sets of triangle for my clients to illustrate the difference between Interest Rate and APR. The reason for the triangle is because there are 3 sources of input…“Interest Rate”, “Mortgage Amount” and “Monthly Payment”. If you know any two of the three, you can calculate the third. See the triangle below.

Since any two of the three variables allows you to calculate the third, a $616 monthly payment for a $150,000 mortgage calculates to an interest rate of 6.125%. But the APR calculation uses different information. The APR calculation only keeps the “Monthly Payment” information the same. Instead of the “Mortgage Amount”, APR uses “Amount Financed”. This is the “Amount Financed” information on the Truth in Lending statement. Amount Financed takes into consideration the fees that are lender imposed. This includes application fees, points, commitment fees…and interim or per diem interest. So, Amount Financed is the mortgage amount less any lender fees, points and interim interest. The more fees, the lower the Amount Financed. The monthly payment is then calculated as a product of the Amount Financed to give you the “Annual Percentage Rate” or “APR”. So the lower the “Amount Financed”, the higher the “APR” is. Amount Financed can be manipulated by assuming a closing on the last day instead of the first day of the month. That would increase the Amount Financed and decrease the APR.

Here is a real example on a $150,000 fixed rate 30-year mortgage with zero points: Lender “A” (triangle above) is offering a great low rate of 5.875% and lender “B” (triangle below) is offering a higher rate of 6.125%.

A closer look shows that Lender “A” is charging $3,000 more in fees than Lender “B”. How do you compare? If you look at APR, Lender “A” (5.875% with $3,000 higher fees) has an APR of 6.149%. Lender “B” (6.125% but a $3,000 savings in fees) has an APR of 6.211%. So according the APR, Lender A is a better deal even though the fees are $3,000 higher…this is exactly what these high fee lenders are hoping you look at.

Let’s look at the real story. The payment difference between the two is $24 per month. So is it worth paying $3,000 in fees to Lender A in order to save $24 per month? Hardly. It will take 10.5 years for a borrower to just to get back their investment! A bad choice when you consider that mortgage loans typically are retired within four years. To make the decision to go with Lender “A” even worse, if that’s possible, borrowers rarely take the value of today’s dollars into account. Rather than giving Lender “A” the windfall of your hard earned $3,000, you should give it to yourself. Reduce the loan balance on your mortgage by the fees you are saving. In the example above that would reduce the loan from $150,000 to $147,000. This makes the payment difference just $6 per month instead of $24 per month! The true time to break even is really 500 months (more than 40-years!). So it is impossible to benefit from the higher fee program from Lender “A” because the maximum period on the loan is 30 years or 360 months. One more thing…when you calculate your tax deduction on the payment difference, it makes even more sense to avoid paying higher non deductible fees. The obvious correct choice is to go with Lender “B” even though the APR is lower with Lender “A”.

Bottom line…your clients should forget APR and think twice about those advertised low rates when they are accompanied by higher fees. Use the above illustrations to drive your point home.

Look Beyond APR in Mortgage Hunt

By Barry Habib
Contributing Editor to CNBC.com

The "annual percentage rate" (APR) listed with any mortgage generally causes more confusion than it’s worth for most homebuyers. Making matters worse, most mortgage professionals don’t really understand it.

An APR calculation is required on mortgage offers to help people make sense of all the figures flying around. The ultimate goal is accurate comparative shopping. Unfortunately, some lenders can and will manipulate APR; and the assumptions used generally make APR estimates unrealistic.

APR is at best a theoretical statistic. Your mortgage carries a stated interest rate. But it actually costs more, when you account for points paid up front and closing costs imposed by the lender. APR tries to take all this into account. Unfortunately, it usually does little more than confuse homebuyers. In fact, the calculations associated with APR frequently scare homebuyers.

Under APR math, you take the loan amount, which is easy for anyone to understand, and turn it into the "amount financed."

Let’s look at an example: If you put 10 percent down on a $200,000 home, the loan amount is $180,000. Let’s say you pay $5,000 in points and closing costs. That means the amount financed is $175,000. Homebuyers panic when they see the $175,000, thinking that they suddenly have to come up with another $5,000 at the last minute to pay the seller. But in fact, that figure comes up merely to calculate APR and has no real barring on the transaction.

Another source of confusion and misleading comparisons stems from what is known as "interim interest." For various reasons, mortgage payments are almost always timed with calendar months. So if you close sometime during the month, then you have to pay that little bit of extra interest until the first payment is due. Interim interest can alter the APR calculation by several basis points, but that does not really mean one mortgage is better than another. It merely means that one closing date is further away from the end of the month than another. Lenders can play games with interim interest to get lower hypothetical APRs on advertised loans. Laws regarding APR actually allow some wiggle room for this sort of thing. A lender can be off by as much as 1/8 of a percentage point. Unfortunately, in a competitive mortgage market that can mean the difference between winning and losing a customer.

Homebuyers generally aren’t aware of the faulty assumptions that go into APR calculations. These assumptions can lead to people taking on the wrong kind of mortgage.

APR math relies on two very bad assumptions:

• APR assumes zero inflation. In other words, $1 today equals $1 30 years from now.
• APR assumes the homebuyer will never move, prepay, or refinance.

In fact, a typical family stays in the same house about nine years, and refinances once. That brings the average mortgage duration down to less than five years.

So most APR assumptions are grossly unrealistic. Adjustable-rate APR calculations are based on even more assumptions, making them even less meaningful.

So what do you do? Take a look at the APR, and then forget about it.

Don’t pay points, unless you plan to stay in the house for at least 10 years and won’t refinance. Chances are good you will move before 10 years is up, or you will refinance.

It is much easier to compare different offers if they don’t include points. You should focus on the type and amount of the mortgage, and on the quality of service of the lender.

Fed Rate Cuts Do Not Equal Lower Mortgage Rates

By Barry Habib
Contributing Editor to CNBC.com

So the Federal Reserve may cut rates again. Many mortgage applicants are calling their mortgage representative and expecting a lower interest rate. Others who have been waiting to refinance are puzzled as to why mortgage rates have not moved lower when the Fed cuts rates. In fact mortgage rates typically move in the opposite direction from the Fed move. This is difficult to explain to consumers who have watched a rate reduction by the Fed with no benefit in mortgage rates.

Is a Fed rate cut really good news for mortgage rates? The facts may be surprising. The Fed can only control the Discount Rate and the Fed Funds Rate. This is very different from mortgage rates. A mortgage rate can be in effect for 30-years, a rate that is set by the Fed can change from one day to another.

A look at some recent history shows that when the Fed cuts rates mortgage rates go up…not down. In the late part of 1998, with mortgage rates around 6.5%, the Fed cut rates 3 times. Mortgage rates shot up by over 2% during the next year. Then, in the spring of 2000 and after 6 Fed rate hikes, mortgage rates declined from 9% to 6.75% over the next 9 months. In 2001 the Fed cut rates 11 times. But mortgage rates were actually higher after the 11 Fed cuts.

Why do mortgage rates seem to defy logic and move contrary to the Fed direction? Most often it is because Stocks and Bonds compete for the same investment dollar. So if stocks like the Fed decision to cut rates and rally, bonds typically worsen. If stocks react poorly to a Fed rate hike, bonds are usually the beneficiaries.

As bond prices rise, interest rates fall. As bond prices fall, interest rates rise. The charts accompanying this article show the Nasdaq Composite Index and the Fannie Mae 6.5% mortgage bond tend to follow paths that are almost mirror images of each other. The consistency of this behavior is astounding.

As the Nasdaq moves higher, bond prices move lower causing interest rates to rise. As the Nasdaq declines, mortgage bonds benefit, causing mortgage rates to fall. Additionally, and unlike common opinion, Fed rate cuts have had virtually no direct effect on mortgage rates. Moreover, it appears that since Fed rate cuts act to stimulate the Nasdaq, they have a negative effect on mortgage rates.

The bottom line is that it appears mortgage rates will get better if the stocks sell off and will get worse if the stocks rally. So it is not necessarily what the Fed does that affects mortgage rates, it's how the Nasdaq and broader stock market interprets the Fed's action that will ultimately influence the direction of mortgage rates. This is because money managers and mutual fund companies typically keep funds in either stocks or bonds with very little in cash. If stocks are in favor, money is pulled from bonds, causing bond prices to drop and interest rates to rise. When stocks are being sold off, the money is then parked into bonds, which improves bond prices and causes interest rates to decline.

On the chart of the Nasdaq Composite Index above, notice how the price movement higher on the Nasdaq seems to correlate to mortgage bond price deterioration (shown below) and vice versa. Once again, lower bond prices translate to higher mortgage rates and higher mortgage bond prices mean lower mortgage rates.

The chart below shows how the Fannie Mae 6.5% mortgage bond has performed during the same time period. The green circles indicate Fed rate cuts and the area circled in red shows when the Fed hiked rates.

A closer look at the 11 rate cuts by the Fed last year (see chart below) shows that mortgage bond prices deteriorated after each Fed rate cut. This means that mortgage rates rose after the Fed had cut rates while many consumers were expecting their mortgage rates to decline. Worse yet are the consumers who missed the opportunity to obtain a lower rate because they mistakenly waited for the anticipated Fed action to cut short-term rates, thinking that longer-term mortgage rates would decline as a result.

Predicting the future is tough, so nothing is written in stone. Keep an eye on the stock market, and keep in mind that the best rates may be behind us. But, mortgage rates are still low and could have some quick dips so make the most of them while they last.