Why I recommend the "right" ARM vs. a Fixed-Rate & if a Fixed-Rate why I recommend a 30 yr. over a 15 yr.

When I first started in the mortgage business back in 1991 I was instructed to offer the normal 30 yr., 15 yr. fixed-rate mtg. and fixed-rate Home Equity loans (no HELOC or Home Equity Line Of Credit back then.) However, as I learned more about the business (by listening to my Client's needs and looking at their loan applications) I quickly came to the conclusion that a fixed-rate was not appropriate for everyone. Around this time I was listening to a local AM radio station when the daily "Financial Planner" came on with his usual reasons for why one should get out of debt and stay out of debt. This well-known author and radio host's main theme was to pay your house off as quickly as possible. He highly recommended that everyone refinance their existing mortgage to a fifteen year amortization; here were his main conclusions:

• You could receive a lower Interest Rate on a 15-yr fixed vs. a 30-yr. fixed
• You'll own your home in half the time and save thousands in interest charges
• You'll build "equity" much faster
• The Rate is fixed so you can "build" your budget around the monthly payment

However, after about 10 minutes he began to take new callers who normally called in to thank him for his words of wisdom; I can't remember if it was the 2nd or 3rd caller when I heard the following dialog, it went something like this.... " Hi, I'm a stay-at-home Mom and I wanted to let you know that my husband and I did what you suggested and refinanced our 30 yr. mtg. to a 15 yr. fixed mortgage; but now I have a question for you. My husband recently got laid off from his job and our daughter has been recently diagnosed with a disabling sickness. So after the new medical expenses and my husband's unemployment check, we are coming up short about $200 p/month. Do you have any suggestions? There was a long pause and the Host said, "have you thought about starting a home craft business?" ... Then they cut to a commercial break.

 I was learning that a mortgage is one of the largest financial transactions one will ever make therefore it seemed more important to offer a mortgage program that not only meet their  home-financing needs, but also had a potentially positive impact on their future financial plans. I realized the appropriate integration of home financing strategies into financial planning could actually turn their mortgage into an asset.  What I came to realize is I had to ask a few questions before I could just quote a proposal/interest-rate; here is an out-line of questions I began to ask:

• Ages and current stability of income &  potential for future income?
• Existing cash-flow & are they having trouble making all monthly pmts?
• How long are they planning on keeping this home (*this is key)?
• Will they be incurring future debt e.g.,  college loans, new car, etc.?
• Are they currently saving an adequate amount of monies for retirement?

* if you are planning on keeping your home for life the most important thing to remember is you want to pay it off in full as soon as possible.

These questions could be summed up with the following question: Do they really need a "lower monthly pmt" or a "lower interest-rate"?

The following discussion regarding the merits of "increasing ones monthly cash-flow" is directed to those who are currently:

• in debt & struggling to make their monthly pmt. obligations
• low savings portfolio
• uncertainty with their current job position
• looking to invest in other profitable opportunities, e.g., 2nd home/investment properties, starting a new business, etc..
• Not interested in keeping your current home for life

For all others, a rapid reduction in their mtg. via a  fixed-rate (or ARM) with accelerated monthly pmts. may be appropriate as I believe if you have no other debt  and have an adequate savings portfolio, you should pay your house off in full. Moreover there may be times when it is more important to pay your mtg. off even if you had other debt and low savings if we were going into a depression.

 A positive cash-flow is absolutely essential if you are to accumulate savings to meet these long-term and short-term goals:

• Tax reduction
• Debt reduction - (pay off home mtg. credit card & installment debt)
• Living expense - (at least 4-6 mos living expenses in short term savings)
• Increased giving - (charitable contributions)
• Fund a retirement program & children's future education

Let's begin with some basic concepts; here are four arguments per Ric Edleman (professional financial  Planner), on why you should carry as big a mortgage as you can:

I. Mortgages don't effect home values.
Everybody likes to own, because homes increase in value. However, growth in your home has nothing to do with the amount of equity you hold in it. The value will rise or fall regardless of the size of your mortgage.
Therefore, having lots of money in home equity is like having money in a mattress: it's not earning any interest. You would never keep $100,000 under your bed, yet lots of people have a quarter million in their walls. In other words, get the money out of the house.

II. Your mortgage is the cheapest money you'll ever buy.
A mortgage (or home equity loan) costs only 6-8 percent and some loans are even cheaper. And you can deduct all your mortgage interest expenses. Most people are in combined federal and state income brackets of 33 percent, so the government subsidizes a third of your mortgage interest. That means that your 8 percent home loan costs you only 5.4 percent. Compare that with an 18 percent credit card, where none of the interest is deductible. Result: Your home is less than a third of the cost of a credit card loan. So, if you have any debts, pay them off; if you can't pay them off with a home loan. In other words, get the cash out of the house.

III. Get the cash out while you can.
Many retired couples have little savings, but they have paid-for homes. When there's a catastrophic situation e.g., illness, costing $3,000 per month in long- term care, the only source of money is the house and the only way to get it is to sell. Result: The couple loses their home of 40 years.
The solution is to take the cash out of the house before you and your spouse retire so that it is available in the event of a financial or medical crisis. Invest your equity in super-safe U.S. government bonds, and use this monthly interest to pay off the new mortgage. In other words, aside from closing costs, the loan will be a wash. If your broker or financial planner is good, you may even be able to earn more in interest than the loan costs you. And you could cancel the whole idea anytime by cashing in the bonds and paying off the mortgage. The point is this: When you have the cash, you have many options. When the cash is tied up in your home, your choices are very limited. In other words, get the cash out of the house.

 IV. A 30-year mortgage is better that 15.
On a $150,000  loan amount at 8 percent, a 30 year mortgage would cost $1,100 per month; but mortgage bankers will tell you that for $333 more per month, you can get a 15-year mortgage instead. Thus, they say, you'll own your home in half the time and save $133,207 in interest charges. Sound great? Yes, but try this: Take the 30-year mortgage and invest the excess of $333. Assuming you earn 10 percent which is no great challenge these days, at the end of 15 years you'll have saved $113,022 after taxes - virtually the same as your mortgage's outstanding balance. So you can pay off your mortgage if you want, giving you the equivalent of a 15-year note. Why do this if the numbers are the same? For all these great reasons:

• Your cash remains available to you if you need it for another property.
• Cash tends to be tight after buying a new home, so the lower payments will prove very helpful.
• That extra $333 mortgage payment goes toward principal, not interest, so there is no tax break on making it.
• You lose your tax deduction quicker on the 15-year note than on the 30-year.
• Your mortgage payment stays fixed, but your income grows with inflation, meaning you get to pay off today's fixed loan with cheaper, future dollars.

In other words, get the cash out of the house. (There is one caveat to this strategy):

•  you must religiously set aside the $333 each month.

If you don't you'll have nothing in 15 years but 15 years left on your mortgage. A good planner of adviser can show you how to set up a systematic investment program so you'll be sure to save that $333.)

O.K. now I'm going deeper into the reasons for increased cash-flow and ideas for investing this extra cash-flow but please keep in mind, the main idea is to first pay off all "other" debt then depending upon your situation (e.g., age, income, ability to take risks, etc.) attack your home mortgage.  With this said, please remember just like the Stock Market, the pursuit of "equity" is a gamble as the Market will go up and down just like the MV of a property whether its commercial or residential.  Therefore you always need to have a large reserve of liquid cash to avoid the eventually down-turn in the Market (i.e., Stock Market or Housing Market.)  If not, you could find yourself in financial ruin if you run into a period of declining values in homes where your equity is declining, or the Stock Market is rapidly declining.

    

1. Compare Payment Differences
Compare the difference between an amortization of a monthly principal and interest payment and an interest only payment for a $300,000 mortgage at 8.125%.*

 Difference: $196 a month

* Amortization payment is based on a 30 year amortization and assumes that rate remain constant. Interest-only payment would only be in effect for a period of up to 10 years, depending on the mortgage selected. Monthly payments after that period would reflect both principal and interest.

2. Options for redirecting funds
. Pay off higher cost, non-deductible consumer credit.
. Maximize contributions to 401(k) or other tax-deferred retirement accounts.
. Increase contributions to an investment portfolio.
. Meet day-to-day expenses (not often recommended unless you are at the beginning of your earnings potential).

Investing "redirected" funds may help you build your net worth says Chuck Carlson (Chartered Financial Analyst). Compare the total amount of principal you would have paid on the amortization of your mortgage with the potential investment earnings from your redirected funds. The difference is the potential increase in your net worth.

E.g., The $196 Invested Monthly During the Past 10 Years; $300,000 example- If you had paid your PI payment for ten years (12/87 to 12/96), your Mortgage Principal Pay Down would have been $36,153.

If you had invested the $196 difference from our previous example into the Standard & Poor's 500 during the same past 10 years, your net worth would have increased by $25,618, i.e. that $196 would have grown to $61,771.  

 As strange as it sounds, debt isn’t always a bad thing. Per Merrill Lynch, debt can help you acquire new assets, earn more money and survive lean times. The trick is knowing the difference between good debt vs. bad debt – and being discriminating about when you go into the red. "There’s a myth that debt is dangerous," said Adriane Berg, a financial expert and publisher of the newsletter, Wealthbuilder. "The best type of debt is when you are buying something that will increase in value, such as a home or an investment property", said Elissa Buie, owner of Financial Planning Group. Loans for school tuition and new businesses are also good debt. "When you take on debt you increase your risk, but you also increase your return," Buie said. If you buy a property valued at $100,000 with a $20,000 down payment, you’d make a *50 percent return if you sold it for $110,000, Buie said  Some people might think it’s better to put a bigger down payment on their home and pay off the mortgage faster. But Buie said "it could be smarter to have a smaller down payment and invest the rest, as long as the mortgage interest rate is less than the expected rate of return on your investments." - (* I think she means "10% return, but you get her point. However, you need to remember that there will be "closing cost", therefore you need to factor in the est. cost to buy the property and the est. cost to sell the property for your true rate of return. I'm thinking Buie is assuming one could buy a property for no closing cost which can be done if the Seller pays for them at Settlement (e.g., Title ins, taxes, attorney fees, etc.) and when you sell, you don't use a Real Estate Agent which I've done before using www.FSBO.com. Even so, you'd likely incur Capital Gains hence increased income for increased taxes. so keep in mind that I'm just giving you "macro" ideas of ways to invest your assumed extra mo. cash-flow by using an ARM vs. a fixed-rate......) 

Ok, so we've talked about how important it is to increase cash-flow in order to pay off debt and establish an emergency saving portfolio. So now what's the most significant success factor in an investment program?

• Picking the right investments?
• Having the proper asset allocation?
• Controlling transaction fees?

Again, I/m not a finical planer nor a CPA, etc. but I have studied investments for many years and the older I get the more conservative I'm.  The older I get I like gold coins and cash. I know that everyone is saying put your money in the Stock Market and Bonds (and if you are very young and especially if your employer is contributing to your 401k, then I'd say put most of your savings there), but owning your home and having real money like gold is something to really think about. I won't go into to it here but can we really trust our government to control the private (non government) "Federal" Reserve Bank it's increasing printing of the dollar?

So back to the basics, i.e.,  Merrill Lynch says while these three factors certainly play a part in long term investment success, the single most influential factor affecting your portfolio is time. If you think about it, time is really the great equalizer among investors.

• Time doesn't depend on having "inside information" on a company.
• Time doesn't depend on having the latest computer tools and investment gadgets to pick stocks.
• Time doesn't depend on having a seat on the New York Stock Exchange and seeing the workings of the financial markets up close.

Time is available to everyone. If time is the most influential factor on your portfolio's performance, it follows that the most important thing you can do is to get started in an investment program as soon as possible. Interestingly, I run into many investors and perhaps your children or grandchildren fall into this group who never get into the game because they believe that you need a lot of money to invest or they think the market is "too high." The later sentiment is especially common given the market's strong performance over the last several years. The problem is that determining whether the market is "too high" is really a loser's game. For example, how many people refused to invest in 1994 because they thought the market was too high only to see the market skyrocket in 1995 and 1996? The point is that every day that you wait to invest, you diminish the value of the one factor that can help your investments the most - time.

 Here are a few examples of just how the power of time can produce huge investment returns and how limiting the power of time (i.e., market timing) can often do more harm than good:

• A 22-year-old who starts investing $50 per month will have nearly $319,000 when he or she turns 62 (assuming an average annual market return of 10 percent). If that 22-year-old waits 10 years before beginning an investment program, he or she will have to invest almost triple the amount (or approximately $140 per month) to achieve the same $319,000 result.  

• Let's say that you want to fund the retirement program of a newborn grandchild. If you invest $4,000 around the day your grandchild is born, and never touch the investment again nor make another contribution, that $4,000 will grow to nearly $2 million by the time the grandchild turns 65 (assuming a 10 percent annual return).
   

In summary, it's more important to get out of non-mortgaged debt and then begin to aggressively fund a savings portfolio, vs. dramatically reducing your mortgage balance because we know that a 30 yr. amortization will give us more monthly cash-flow than a 15 yr. or 20 yr amortization (again assuming you are younger and or not planning on keeping your home for life.)

So what about a 30 yr. fixed-rate vs. a 30 yr. ARM?  Wouldn't an adjustable rate mortgage give more cash-flow then a fixed-rate mortgage as we would be taking on more risk?  If so, we should be rewarded with lower monthly payments. (at least in the early years of the loan.)

Let's begin with a few thoughts on fixed-rates:

Julie Clairmont (REA) says “Some people opt for fixed-rate mortgages because these mortgages have been around longer than adjustable-rate-mortgages (ARMs) and compared to ARMs, fixed-rate loans are easier to understand. Unfortunately, that means some people are using the wrong criteria to select their mortgage loan,” according to the authors. Right again, says Chris George, president of CMG Mortgage, Inc., “Buying a house and getting a mortgage is an ominous prospect, especially for first-time buyers, so a lot of people say, Let's take the variables out of the experience and get a fixed-rate loan. “In general, he says, many consumers don't understand the dynamics of the mortgage business, which leads to confusion over what type of loan to choose; they don't understand on average":

• People change loans every 38 months

• Interest rates tend to cycle every three-four years

• Political factors and election years tend to affect rates,” he says
  
  Statistics show again and again that most people:
   

• Don't live in their homes long enough to make a fixed-rate loans the wise choice,  think about the future, not just the present
• History has proven that few ARMs have ever reached their actual life cap rate
• Death, job relocation, the desire to remodel or add a pool are all factors that drive people to refinance or move more often than they tend to predict

“Half the people I sit down with will get divorced, which usually means the house will be sold.” There are some scenarios where a fixed-rate might be preferable, says George. “They're great when your family is a little further down the path, maybe your kids are in high school, or going to college,” he says. And some people are simply not comfortable with ARMs, and never will be, say both brokers.

So what is the best ARM?

The right ARM would give you more cash-flow and could give you a more favorable interest-rate than a comparable fixed-rate mortgage (apples-to-apples, i.e., same loan amount, same cost, etc..) E.g., if you had received a fixed-rate mortgage over the past 15 years, you would have most likely refinanced 3-5 times in order to get down to the recent 5%-6% Rates of today (i.e., 2005 & 2006); however, if you had received the right ARM, you would have saved thousands of dollars by not having to refinance over and over again paying all those Settlement fees as you would have a comparable interest rate today, i.e. 6%-7% range.

As an example, as of 11/2006, if you had obtained a MTA-Indexed (*Pay Option ARM) mtg. with a Margin of 1.90% fifteen years ago and had been making the fully-indexed pmt. (index + margin):

• you would have "averaged" an Interest-Rate of 6.16% or (1.90% + 4.261%)
• you would only have 15 years left on your loan balance
• you would have incurred no negative amortization

Now the risk of any ARM vs. a fixed-rate is the ARM can move higher than the fixed, but you need to compare apples-to-apples, i.e. history. For example, let's say you received a 30-yr. fixed-rate for a $250k mtg. back on 01/01/93 for 8.5% (zero points) and you could have also received an MTA-indexed Option ARM with a 1.90% Margin with its Index at 3.95% for a fully-indexed Rate of 5.85% (again assuming the same loan amount, no points, etc..); you would have been better off with the Option ARM even though today (as of 11/01/06) your MTA-indexed mtg. would have a higher fully-indexed Rate of 6.73% or (4.83% + 1.90%) which might be slightly higher than what you could get on a fixed-rate today, but again, you need to remember that you would have needed to refinance several times (on the fixed mtg.) in order to get down to that low 5-6% fixed rate of today i.e., 2006 and 2007.
                      
People always ask me "why have I never heard about this *mortgage program? " My response is that Real-Estate Agents control most of what you're going to be taught about mortgage options when you buy your home. My experience with RE Agents is they like to keep things "simple" when it comes to your financing options. They usually recommend a 30 yr. fixed, 15 yr., or a traditional ARM like a 5/1 or a 7/1. Also, there are only a hand full of Lenders in the US that offer this program, and most RE Agents and Builders have their own Mortgage company that will want to sell you what they offer, e.g., 30 yr. fixed, 15 yr. fixed, or 1 yr. ARM. 

The reward of obtaining a "Pay Option" Adjustable Rate Mortgage is you have the option to start off with lower mortgage payments. The lower payments could help you  stay out of future credit card debt or get you out of existing credit card or automobile debt. If you have no debt the lower payments will help you quickly build up a savings portfolio. There is a difference between a "lower interest rate" vs. obtaining a "lower payment" as with the Option ARM you'd have at least 5 different pmt. options and with the fixed-rate you'd only have two. With lower payments you can leverage your future house payments in a more beneficial way. The risk of obtaining an ARM is the possibility that your payments, loan balance and interest rate could move higher then the fixed-rate; however you need to remember that when the fixed-rates start to move back down the Option ARM indexes will also start to slowly inch back down. Keep in mind it's the "over-all" average of the Index along with its Margin (fully-indexed rate) as the most important aspect of any ARM. Therefore with the right Option ARM you might never need to refinance again. Most folks I've put on these ARM's {including my own house} since 1991 until today have a fully-index rate (Index + Margin) in the mid 5-6% range (this is true as of 03/01/2008); this includes Jumbo loans. I started teaching my clients about the COF Index back in 1991 (and now the MTA index.) I personally believe a COFI or MTA Option ARM is a better loan for my family then any fixed-rate mortgage because of the option to increase our monthly "cash-flow" by making just the "Minimum" payment (deferring Interest.) We also understand how and why these Indexes move along with their safety caps, i.e., yearly payment cap and life cap. Because of this knowledge we are not worried about having our future payments go so high that we could not afford them. Many of my potential Clients have already heard a little bit about these mortgages however they have not fully understood them. Many have been told to stay away from "negative amortizing" loans but once they understand that a Home Equity loan (2nd mtg.) can also produce negative amortization (i.e., your mortgage balance can increase) they begin to look at the "Minimum" payment "option" in a new light.

It might take some time to read and digest all this information so you may want to bookmark this page. I've tried to put all the information that I could find since I began teaching about the COFI Option ARM beginning in 1991 on the following pages. If you have any questions, please send me an e-mail. The next link will teach you everything you need to know about the Pay Option ARM - *Understanding the Option ARM

 

More on the merits of increasing your cash-flow and becoming a millionaire