One thing that I’ve been getting a lot of requests about as a Manchester mortgage advice consultant is the ongoing mortgage mess in the US. I wrote a bit about it a while ago, explaining what was going on. But since then, I’ve gotten a lot of people asking me to explain various things about how mortgages work, and what kinds
of trouble people have gotten into.
Mortgage Basics
The basic idea of a mortgage is very simple. You want to buy a house, but you don’t have enough money to buy it up front. So you borrow money to pay for it. A
mortgage is a loan that provides you with money to purchase a house, using the
house itself as the collateral for the loan – so that if you can’t pay back the
loan, the lender is allow to confiscate and sell the house in order to
recover their money.
The mortgage loan is paid back monthly. Normal mortgages are set up using a
simple mathematical structure. You choose a term for the mortgage –
typically 15 or 30 years. The lender chooses an interest rate to charge you. Then
you work out a monthly payment where, if you make the same payment every month,
after the term is over, you’ve the interest rate on the outstanding balance of the
loan each year, and you’ve also payed off everything that you borrowed.
There’s a fairly simple formula. Suppose that you want to borrow P dollars. You want to make a total of n payments. The interest is charged at a rate
of i percent interest per payment period. Then your payment per period can
be given by an amortization equation:
Payment = P ×(n/1-((1 / 1+i)n))
So, if you took out a mortgage at 5% on $100,000, with monthly payments,
and interest charged monthly, then your payment would be 100,000 × (0.004 / (1 – (1/1.004)360)), or roughly $525.
Now, I’m going to get lazy. There are a ton of amortization calculators
around the net; the one that I used calculates based on interest
charged yearly, so the end-result is a tiny bit different – $536 per month, rather than $525. But just that difference should drive home an important fact: even seemingly trivial differences in the exact terms of a mortgage can make
a big deal.
Using the bank’s amortization calculator (I used one on fidelity.com),
on the $100,000 mortgage at 5%, yearly. You’d pay $536.83 per month.
At the end of the year, you would have paid $6442. $4966 of that would have been
interest, and $1476 would have been actually paying back the money that you
borrowed. The part of the payment that is paying back the money you borrowed is
called principal. (You might think that the interest the first year
should be 5% of $100,000; but the interest is always payed on the outstanding
balance, so each month as you pay it down, you’re reducing the amount borrowed. So
you don’t end up paying 5% of the full mortgage value the first year.) The second
year, you again pay $6442, but now you only pay $4891 in interest. And so on,
until the 30th year of the mortgage, when you pay less than $200 in interest.
When you own a house with a mortgage, you can think of it as you and
the bank co-owning your house. You really own part of it – the difference
between the price you could get by selling the house, and the amount of money
you still owe to the bank. The value of the part of the house that you really
own is called your equity. Your equity is equivalent to
the sum of your downpayment on the house, plus any change in the value
of house since you bought it, plus however much of the principal of the loan
you’ve paid back.
The monetary value of owning a home comes from equity. If you’re paying
rent, you’re giving money to the owner of a house, and you’ll never get any of
it back. With a house, you can often get back your equity when you
sell the house. So if the value of the house never changes, you get back part of your monthly payment when you sell the house; if the value of the house increases,
then you can think of it as having earned income on your principal.
Fancy (or Crazy) Mortgages
That’s a simple mortgage. Things in the real world get a lot more complicated. One of the complications is something called an adjustable rate mortgage (ARM). In an ARM, the interest rate changes. Depending on your contract with the mortgage company, the interest rate on the loan can change at certain intervals. Each time the interest rate changes, it’s called a reset. Each
reset, the outstanding balance stays the same, and the monthly repayments
are recalculated using the new interest rate, the outstanding balance, and the number of months left on the mortgage. Suppose that in the $100,000 example, there was a reset after 5 years, which raised the interest rate to 7%. At that point, the outstanding balance would be 91,829. With 300 months left on the mortgage, the
new monthly payment would jump to $649. Altering the interest rate by 2%
changed the monthly payment by about 17%. Small changes in the interest rate
can translate into very big changes in the payment!
Depending on your ARM, you can see multiple resets, creating a huge
change in payments. One of the standard tricks during the great mortgage
mess in the last few years was something called a teaser rate: basically, a bank would offer you a mortgage with an initial interest rate that was incredibly low – some teasers went as low as 1.2% for the first two years. But once they start resetting, they reset to the current standard interest rates, not
the low teaser rate. So people who fell for teasers could see their mortgage rate change from 1.2% to 8% over the span of a couple of resets. In terms of
payments on a 30 year, $100,000 mortgage, that’s changing the payment from $331
at the start, to $617 after resetting to 7% four years into the mortgage.
You can see from this that taking an ARM could be an incredibly
stupid idea. If you only plan to live in the house for 3 years, and the loan
doesn’t reset for three years, then the teaser rate could be a very good deal. But
if you didn’t think it through, you could be royally screwed. An awful lot of
people took ARMs when they really shouldn’t have – some because the banks
refused to offer them anything else; some because they were talked into it
by a fast-talking salesman; and some because they were just plain stupid.
But it gets much worse than that. After along conversation with some folks at Irenas Xero bookkeeper in North Shore, I learned that, A lot of people took
what’s called an interest-only mortgage. That’s not really
a mortgage. The idea is that the bank loans you a bunch of money to buy a house, and every year, you pay back just the interest. So in our example, that means
that every year, you pay the bank $5,000. The idea behind this is that
if the value of the house increases, then when you sell the house, you’ll
be able to pay back the loan and still come out ahead. This is what’s known
as a really bad idea. It was used by a lot of people to buy houses
that they really couldn’t afford. It doesn’t even save you that much – in our example, it saves you $1500 over the course of the year – just a little over $100/month.
But it gets dumber than that. A lot of the interest-only loans
were also adjustable-rate. So people were buying houses that they could
barely afford to make the interest payments on, under terms that allowed
the lender to change the interest rate by more than the difference between an interest-only loan and a normal mortgage!
But it gets dumber than that. There were people who wanted to buy
homes even further beyond their means. So they took what’s called a
negative amortization loan. In that, the bank charges you
a particular interest rate per year; you make payments to them that are
less than the interest rate that they’re charging. So the amount
that you owe to the lender is increasing. When the loan term is up,
you’re expected to pay back the outstanding balance – the original amount that you borrowed, plus the outstanding interest. The idea behind it is that if
the rate at which the debt is increasing is slower than the rate at which the value of the house is increasing, then you’ll still come out ahead when
you sell the house.
HELOCs
Another different but related kind of stupidity is something called
a HELOC, which stands for home equity line of credit. In a HELOC,
you’re taking out a loan secured by the equity you have in your home. In the
old days, HELOCs were called “second mortgages”, and were considered a last-resort
thing to do: if you were in serious financial trouble, you could take out a second mortgage to get some money.
Re-naming them as HELOCs is part of a rather obnoxious scheme. The idea is
that lenders portray HELOCs as “cashing in your equity”. They try to make it
look as if your house is a sort of ATM: you put money into it by paying off
the mortgage; you take money out of it by drawing on a HELOC. It’s presented
as a way of accessing your money.
The problem is, it’s not. It’s a loan, which uses the piece of your home that you own as collateral. And it’s often a really bad loan.
To give you an idea of just how foolish this has gotten, I recently saw
an article talking about how many people had used HELOCs to buy cars. If you
think of it as your money, that seems like it makes sense. You need
a car; you’ve got a bunch of money in equity on your home – why not use your
money to buy the car instead of taking out a loan? HELOC vendors have done their best to convince you to see it that way – that it’s just using your money.
The reason that that’s stupid is that HELOCs are loans. If you
compare the terms of the HELOC to the financing terms being offered by car
dealers, the HELOC is often absolutely horrible. Just for example, I looked
at the current rates. In Westchester county, where I live, there’s an ad in the paper for a Honda dealership offering 2% financing for people with good credit. The current HELOC rate for people with good credit is between 4.7% and 4.9% – more than double! And that 4.7% is a teaser rate: it’s variable, with the interest rate reseting weekly, with a maximum rate of 15%! The 4.7% rate is fixed for the first three months – and then it starts to reset weekly.
This is plenty long, so I’ll stop here. Next part will be about
how banks handle mortgages, and what can go wrong.
So, do you have advice for potential first-time home buyers: what specifically to look for, what to fight for or haggle, etc?
Coturnix: Get a simple/normal/old-fashioned mortgage with the lowest fixed rate possible with the highest down payment possible. If rates drop in the future, you just refinance into another fixed rate mortgage with the new lower rate. Easy. This way you never run into the trouble of an adjusting rate. (This assumes you plan to buy the house and stay in it for a number of years – if you’re going to move shortly, the situation is a bit different – but honestly, if that’s the case, I’d personally suggest just renting instead as it’s financially safer/more-consistent and doesn’t have the hassle of being stuck with a house that doesn’t sell when it comes time for you to move.)
There is a another type of mortage, not sure if it used in the US but it used to be popular in the UK, and that is the endowment mortgage. In that you take out the loan at either a fixed, or more normally a variable rate (most UK mortgages are variable rate) and pay the interest due each month. At the same time you also pay a set amount that gets invested by the lender as part of their usual investment portfolio. At the end of the mortgage term the set amount paid, and the interest is used to pay of the loan. If there is any surplus the house owner gets to keep it. If there is a shortfall they are expected to make good.
These mortgages are no longer that popular in the UK after a number of lenders mislead borrowers as to the dangers of their being a shortfall.
I cover these types of calculations in the freshman-level Gen Ed mathematics course I teach. One of the assignments I give is to have students identify a house (or a car, calculations for car loans are virtually identical) they may really be pursuing or want on a whim, get info on interest rates, and then we crunch the numbers. Because of time and mathematical level, we work with traditional loans only. They really open their eyes when they calculate how much of each monthly check goes to interest, how much of each check goes to principal, and how much they are required to repay. I saw this stuff when I was in high school, but most of them have never seen it. I think more people should see this stuff early in life.
Well, we got a 7 year interest-only ARM at 5.25%, but that’s ’cause managing it WELL it makes a good safety-net: if you’re out of work and living on unemployment insurance and the single paycheck of the other spouse, you can temporarily reduce your payments to the minimum/interest-only level.
But that is only the last resort and we only had to do it 2 months. normally, it works well for the buyer if the buyer pays principle over the minimum payment, which we certainly do (usually by a thousand or more).
and we do plan to sell the house before the ARM is up, hoping the local market (DC suburbs, Northern Virginia) recovers enough when the time comes in 2010 or so.
The real hassle for some areas that boomed too quickly and now are in foreclosure-central (Detroit, for example) is that the housing prices rose so fast that some people bought houses at the peak and now have massive loans with no equity that are larger than the value of the house itself – they can’t re-fi ’cause they don’t have any value to work from, but they can’t sell without taking a loss large enough to prevent them from being able to buy elsewhere.
If they can hold out, they’ll be making ridiculous payments but maybe the house value will go up again in the future.
But if they default (because they fell for any of the stupid things you mention here), the banks are holding on to properties they can’t sell for enough to even get the original buyer out of the debt to the bank, and thus are eating those losses even after the house is sold.
Some of the people lost out ’cause their only income was working in house construction and improvement – when the market collapsed for others, they lost their jobs and suddenly their own houses were defaulting and contributing to the market collapse that had already cost them the house in the first place.
Now combine all that with the tranching and other stupid stuff the banks and investors were doing to themselves (as you wrote last year) and it all just exploded, didn’t it? sheesh…
Legally, you may not own any of your equity.
If the bank runs into trouble, they can call home loans. If you cannot come up with the money to pay off the loan, they can sell the house (since it is theirs) and leave you out on the street with nothing. At this point your ‘equity’ equals zilch.
Back in the 70s there was a lot of this in Texas when double-digit inflation got a lot of banks into trouble. Homeowners (well, really ‘mortgage payers’) refused to believe this could possibly be legal, but it was.
And since then, which way have the courts been going, in favor of Joe Blow or MegaCorp?
(OT) ack? type-key didn’t seem to work and turned me into anonymous…
typo on the payment definition
Payment = P ( n / ( 1 – ( 1 / (1 + i) ) n ) )
Hate to break this to you, but you have a rounding error in your payment calculation. The payment is calculated monthly, as you say, but you’re using a monthly interest figure of 0.4% (0.004) in your calculation. The correct figure is 5%/12 = 0.4167% p.m., and that gives the $536.82 figure. That 0.4% p.m translates to 4.8% p.a., not the 5% in the problem.
Those sites you refer to are correct to return $536.82 from those parameters – it’s the same TVM (Time Value of Money) calculation method you find in calculators such as the HP-12 or in Excel. If only more borrowers learned to do such calculations before going to the broker..!
PS It just occurred to me that you may be thinking that the 0.4% per month is compounding, over the year, to give a rate of 5%. This would be true if the bank was quoting an APR* of 5%, which is more “truthy”.
As things stand, however, especially in the USA (compared to Europe), an interest rate of “5% calculated monthly” is liable to be done the way I described in my previous comment, and that compounds to an APR of 6.17%. Caveat Emptor, eh? 8-/
* http://en.wikipedia.org/wiki/Annual_percentage_rate
stereoroid, a correction: 5% compounded monthly compounds to a bit under 5.12% APR.
The endowment mortgage that Matt Penfold mentioned as being popular in the UK was, as I understand it, popular mainly because of the tax implications. Income tax was not paid on money that was used to pay the interest component of mortgages. It therefore was advantageous to not pay off the debt and keep the interest component high, while simultaneously accumulating funds in an interest-earning account until the accumulated funds (less interest) were enough to pay off the principal, with considerable savings on the tax. I have been out of the country for several decades so do not know if this tax loophole still exists or if it has been closed.
Mark,
> But it gets dumber than that.
a significant portion of those “crazy mortgages” were made to finance speculation on rising prices. People never intended to hold the mortgage for several years because they never intended to own the house for more than a few months.
Once the housing boom ended they got stuck with the house and the mortgage…
another typo!
the payment formula and the example dont match.
Payment = P ( n / ( 1 – ( 1 / (1 + i) )^n ) )
should probably be
Payment = P ( i / ( 1 – ( 1 / (1 + i) )^n ) )
Re the UK endowment mortgage… not only was there tax relief on mortgage interest payments, the endowment savings vehicle was a life assurance policy.
Life assurance premiums were also tax relievable at that time. The premium tax relief has long gone, and the interest relief is gone too.
http://en.wikipedia.org/wiki/Endowment_mortgage
There are two types of simple/basic repayment mortgages.
One allows you to pay back more of the capital than you need to and so reduce the interest repayment accordingly and/or reduce the term of the mortgage; the other type charges you the full interest as intially calculated even if you pay back the capital early.
The second is similar, in effect, to a loan under sharia law except under sharia the monthly repayment cannot change as, of course, there is no usury allowed.
The current mortgage problem came around because so many home buyers bought into the myth that lenders and realtors are your friends. Not so. Always get advice from someone who doesn’t stand to profit. And don’t try to live above your means.
I bought a fixer-upper years ago with a small 15-year mortgage. The bank said they “don’t do fixed rates”. OK, I got a five-year reset. Five years later, interest rates were DOWN, but they wouldn’t adjust the mortgage unless I paid closing costs -again. I was so pissed off (I didn’t have money for closing costs) that I paid off the loan in nine years total. Now I don’t pay rent or mortgage, which is wonderful, but this situation makes it really hard for me to relocate during the current meltdown.
I am in my second home, and both times, with several different realtors, they tried to convince us that we could afford a house TWICE what we actually could make work.
Not mentioned is that one often has the annual property taxes and home-owners insurance diced into monthly payments that are figured in with the monthly mortgage payment.
andrea
Comments on two comments –
#5 by anonymous: So you figure that it is “managing well” and having a “good safety-net” to be stuck in a situation that requires a highly volatile regional housing market to be in good shape when you need to sell in less than 18 months? IMHO it is this type of ability to rationalize taking on a degree of risk that to me shrieks “Danger, danger, Will Robinson!” which gets so many people into financial trouble.
#18 by andrea: Good point – you have to have the money for monthly tax and insurance payments, or save enough to pay the taxes in a lump sum. You can avoid insurance payments if you make a high enough down payment (usually about 20%), but hardly anyone does any more.
#5:
I don’t mean to be particularly obnoxious or to pile-on – but your argument makes
*terrible* sense.
If you’re in an uncertain financial situation, where you’re out of work, and you can’t afford to make proper mortgage payments on your home, then you shouldn’t be taking out an ARM, which has the potential to dramatically change your required payments. The idea that somehow, doing that is a sensible safety is incredibly foolish. If you’re in an uncertain financial situation, the last thing you want to do is put yourself into a situation where your housing cost can increase dramatically without warning.
In my opinion, it comes down to an all-too-common bit of foolishness. People want to be able to buy homes that are really beyond their means – so they resort to these kinds of tricky gimmicks to find a way to afford a home that they really can’t.
If you can’t afford to make the payments on a real mortgage – a mortgage that pays off your home over 30 years – then you can’t afford that house. This isn’t rocket science. The point of a mortgage is to spread out the cost of buying your home. If spreading the cost of buying the house over 30 years doesn’t put it within your means, then how can you really argue that you can afford it?
(I’m #5 – as i said, typekey screwed up on that.)
I wasn’t in “uncertain financial situation” at the time my wife and I bought the house in early 2002. I had been at the same job for 5 years, making almost 6 figures; my wife was at the same job for 2. Trust me, every single layoff we’d been through (my one, her 3) in the years between then and now have been a surprise and a shock. We are both university graduates in the high-tech sector, neither of us working for a “start-up”-like volatile situation. We were working for government contract firms, often for the DoD.
2003 saw, thanks to the current administration’s insane policies, a HEAVY hit to many government contracting corporations throughout the DC area. Plenty of once-thought “stable” jobs disappeared as the government failed to meet expected plans in awarding contracts, programs were dropped, and other programs changed. Corporations had difficulty keeping people on the payroll on overhead waiting for the situation to stabilize.
If anything, your argument proves that ARMs simply suck AT ALL TIMES, because unless you’re on the tenure track at some University, you HAVE NO JOB SECURITY. Ever. There simply is no such thing as a “certain financial situation”, by your counter-argument.
Yes, many did buy during “uncertain” times, including many of the houses in foreclosure in my suburb, but please do not accuse that of me. In many employment sectors such as software development in DC, nobody expects to end up screwed, even briefly.
#19 – We last re-fied in 2004, for a 7-year limit before the rates could adjust, before the bottom dropped out. It’s not like we did that “yesterday” and expected things to beautifully recover in a mere 18 months. If we don’t think things will recover to sell, we’ll just re-fi again (and soon) while the rates are still low. Personally, we’d like to sell and move, ’cause the house is fine for 2 + pets, but small for a family.
It’s not like the ARM can be adjusted at will – we know exactly when it will flip and will take the measures needed to keep to a consistent payment. In short, we’re paying attention to it.
It’s that lack of attention that hit so many others, but please do not assume that it will hit me. We actually bought *under* what we could have gotten given our income and initial down payment – the interest-only factor was for that safety-check if needed, not to have a house above our means.
At no point did I say that what we did I would recommend to everybody, just that not everybody falls for the crap the banks were doing at the time.
ack – sorry, that bold section wasn’t supposed to be for that whole paragraph. makes me seem angrier than I actually was. I’m just having loads of fun with commenting here this week. 🙂
Joe Shelby wrote: We actually bought *under* what we could have gotten given our income and initial down payment – the interest-only factor was for that safety-check if needed, not to have a house above our means.
Joe – What you think of as “safety” differs from my conception of the term. You evidently think of it as being able to hold some money in reserve. I think of it as both being able to hold money in reserve, and as not unnecessarily taking on market and interest rate risk.
You say that “If we don’t think things will recover to sell, we’ll just re-fi again (and soon) while the rates are still low.” Have you anticipated that, as has been true all through this crisis, interest rates will rise *first*, which will only then show everyone that things will not likely “recover to sell” in time?
Do you think you can reliably anticipate an increase in rates before it occurs? If you do have that ability, why didn’t you re-fi to a fixed-rate mortgage during the couple of years that interest rates were at 40-50 year lows, and lock in that low rate (and the corresponding low payment)?
You also say “In many employment sectors such as software development in DC, nobody expects to end up screwed, even briefly.” Joe, risk *is* unexpected trouble. What people are saying when they advise risk avoidance is to put yourself in a position where you will be relatively OK even if unanticipated problems occur. (Though after 4 layoffs, sustained volatility in interest rates and the housing market, and the scheduled ARM rate increase, I wonder if one could reasonably use the word “unanticipated.”)
If you do have that ability, why didn’t you re-fi to a fixed-rate mortgage during the couple of years that interest rates were at 40-50 year lows, and lock in that low rate (and the corresponding low payment)?
Because this is my first house and I knew damn well I’d be moving. I have no intention of living here forever, or even 30 years. The house is the right size for a DINK family (double-income-no-kids), but for the amount of “stuff” we have, and the location relative to the best schools in northern virginia, it is not where we will be later on as we grow as a family.
We took a 7 year interest-only deferred ARM because in 7 years from getting it, we had no intention of being in the same house. It was better (at 5 1/4) than getting the 30 year (at 5 7/8), and we are still paying principle over the minimum payment, but had that safety-net to not pay quite so much for the short time that the job market was crappy to us.
Better that than not making payments at all and getting a permanently crappy credit rating (and joining the one house in 20 here that’s on the foreclosure market).
We still intend to sell and buy elsewhere (in the area), in which case we’re subject to the market interest rates of that time (2010 it looks like) NO MATTER WHAT. As long as we knew that 2010-ish was when we’d be forced to face whatever the market was at the time, then it really didn’t matter, did it?
We looked at our future and considered all the options based on the intent to sell the house and move before 7 years was up. That prediction still stands.
Please stop trying to apply “20/20 hindsight” to all of this. The layoffs were all AFTER we settled on the current deferred ARM, as was the start of the housing crisis. As I wrote elsewhere, it’s not like we did this “yesterday”.
Would I do it in hindsight if I had to do it over again? Yes. The “we’ll move within 7 years” aspect would be unchanged. Would I do it tomorrow on my next house? No, because I would be looking at a house for longer-term prospects of living, the house to raise my children in for the duration.
There’s more to buying the mortgage (and house) than just the interest rate.
Please stop trying to apply “20/20 hindsight” to all of this. The layoffs were all AFTER we settled on the current deferred ARM, as was the start of the housing crisis.
I’m not applying hindsight. (More on this below.) The point I’m trying to make is that it’s a good thing to insulate yourself from risk to the extent possible. Here are the top two definitions of “risk” from an online dictionary, my emphasis added:
1. The possibility of suffering harm or loss; danger.
2. A factor, thing, element, or course involving uncertain danger….
You say you would have sold in 2010 anyway. But won’t you feel at least a bit perturbed if you have to sell in January 2010 and the market recovers substantially that summer? (Substitute your actual adjustment date and 6-8 months afterward.)
Getting a better interest rate is of course a good thing. Do you have some calculation of the difference in the amount of money going toward interest over 7 years? One measure of the deal (or gamble, if you want to look at it that way) you have made is the amount of increased interest you would have paid vs. whatever increased risk of future loss there is from not having the freedom to pick the best selling time, or worse comes to worst, not being able to sell or re-finance and having to pay the higher interest rate.
While you’re correct that in 2002 no one knew the housing crisis would come, it was certainly known that interest rates were heading toward 40 or 50 year lows. It could be reasonably anticipated that rates might well rise from those historic lows at some point in the next 7-8 years. When rates go up, prices come down.
This isn’t me speaking with the benefit of hindsight. It’s what my wife (then girlfriend) and I planned for when we looked at mortgages in the summer of 2003. We wanted to lock in rates at those historic lows, knowing we’d have the option to refinance if rates dropped substantially lower. (I say “substantially,” because there are usually considerable costs associated with refinancing.) We found a construction loan that rolled over into a 30-year fixed at the same interest rate, thus locking in our rate not only for the life of the mortgage but during the 8 months it took to build the house.
Between the low rate and 20% down, we, like you, have the ability to pay less for a time if we want to, and we are making additional principal payments. Because the major portion of our current payments is interest, the payments and interest-principal split are probably not that different from yours (adjusted for loan amount). In return for whatever amount of interest the 30-year fixed vs. ARM may cost, we are freed from any pressure to sell before an adjustable rate rises.
Jud said “#18 by andrea: Good point – you have to have the money for monthly tax and insurance payments, or save enough to pay the taxes in a lump sum. You can avoid insurance payments if you make a high enough down payment (usually about 20%), but hardly anyone does any more.”
Actually, the 20% equity requirement to not pay insurance only applies to PMI (Private Mortgage Insurance). It is only used to protect the bank incase the home owner cannot pay the mortgage.
You will still need regular homeowner’s or fire insurance for things like burglary, fire, and other things. Additional insurance riders are needed for things like specific jewelry pieces, flood and earthquake damage.
For our first house bought in 1981 (at 14% interest!) the lumped payment included property taxes, homeowner’s insurance AND the PMI. The PMI was removed when we refinanced down to 9% interest and the value of the house increased enough to bring the equity from about 5% to 20%.
We improved that house on our own, paying cash instead of getting loans. After ten years we sold it for between two to three times what we paid for, and bought a vacant lot with the cash. Then we got a construction loan to build a house, where we did lots of the work ourselves (the bank considered the vacant lot as the equity).
Because of the greater equity in the new house we were able to skip the PMI, plus we pay the property taxes and insurance bills ourselves. I have a monthly automatic withdrawal of funds from our regular banking account to a money market account, which I use to write two checks per year (one to the county and one to the insurance company… also, I changed insurance companies last year to a better one).
An aside on the construction loan: the bank insisted it had to be an ARM, and we could not change it to a regular loan until the house was certified as “finished” (which was different from the city giving us a certificate of occupancy). The bank insisted that all the doors be installed (we had lived in our first house without closet doors for years!), and all the wallboard edges be finished. After about 18 months I did get a call from the bank asking if we finished! They sent a representative over to check it over, and switched the loan to regular.
When the ARM went from 6% to 8%, I switched to a 7% conventional. Then a few years ago we refinanced to 5.25%… dealing with the most clueless bank employees on the face of the earth. AAARGH!!! I call that my summer of financial torture. I am amused when they send me offers to refinance again.
Interest-only mortgages were, I think, initially offerred only to very sophisticated buyers with nontrivial net worths. I have a friend who works in investment banking; when he bought his house, he chose carefully (to get appreciation) and selected an IO mortgage because money tied into his house would, in all likelihood, perform less well than the equivalent amount of money managed in his portfolio. I know this person well, and I know that this choice worked out very well for him.
However, 99.99% of the people in IO mortgages have no idea what they’re doing, and are not saving at all, let alone investing as wisely as a full-time analyst can, so in the general case the only acceptable mortgage for most people remains a fixed rate traditional loan.
Well this was interesting, but I should point out that neglecting the tax-impact of the home equity line of credit skews comparative analysis. And while tax situations are highly personal and volatile, we generally should include them when they’re relevant to the analysis. If only for comparative purposes.
For the average homeowner, itemization is a way of life for the first twenty, or so, years of a home loan. A HELOC, by virtue of it’s deductible nature, (on the first $100K of principle) can be (but isn’t always) subsidized through tax savings.
An example of where a HELOC might make sense: suppose you buy a new car at $25,000. It’s not a luxury car, but it’d be a decent, reasonably economical commuter car. At 7%, your monthly payment is $495. Your interest (pure calendar) would be: $1,612; $1,300; $964; $604 and $219 in years one through five, respectively. If this were an auto loan, the interest would almost certainly not be deductible, though there is a chance if you’re self-employed. (Note, current average 60-month auto loan interest is 6.77%, not much different than the 7% HELOC interest I can get from my bank, SunTrust.)
If your state tax rate is 5% and your federal rate 25%, you, for the sake of simplicity, avoid 30% of the interest through tax savings. Which could take the form of refunds or a lower amount due. In this case, the $4,699 of interest will generate $1,409 of tax savings leaving a net interest cost of $3,289.
Another trick, for the self-employed, is that you can use the interest tracing rules of Sec 263 to deduct the interest in a more favorable context. Perhaps you’ve started your own Schedule C (self-employed) business and you’ve transferred HELOC funds to the business. Not only would you save against the 30%, but you could assign the interest to your Schedule C and further avoid self-employment taxes at 15.3% (less the AGI tax benefit).
None of these examples means I endorse willy-nilly HELOCs. I actually despise them and all other consumer financing via home equity strategies. In my personal life, not only do I not have a HELOC, but I pay extra principle each and every month, have no credit debt, including auto debt and pay cash for everything and save about 12% of what I make.
However, there is more to the picture than “HELOC BAD.” And there are other factors than just gross interest rates to compare.
Now, I don’t like HELOCs because in times of trouble, you have all your eggs in one basket. I feel as part of risk-management it is better to have your second car repossessed and buy some crappy sled or just take the bus than lose your house and be homeless.
I rent – I wouldn’t *dare* take out a mortgage. An ARM (the norm, here in oz) is a blank cheque – permission for a bank to charge you *anything it wants*. “Market Rate”, indeed.
Plus, houses are overpriced for what they are. A house for a average working stiff costs more than an average working stiff will earn in a lifetime. Something’s got to be wrong.
Of course, the root of the problem is income inequality. The guys with money have so much of it that there’s nowhere to put it all, so it goes into housing and other “safe” investments, driving the prices up.
I confess to using a home equity line of credit (HELOC).
We used it for the house we built in order to do some landscaping. Since we had equity amounting to at least a third of the value, it made sense.
Then when we refinanced the house from 7% to 5.25% I added the HELOC debt to the mortgage, and still had lower monthly payments.
I did not cancel the loan. I wrote lump sum checks to the orthodontist on it for each of the three kids. At this practice, if you pay for the estimate up front you get a 10% discount. I called it “teeth remodeling”.
And then just before time allowed to write checks on it expired we had major repairs done on the exterior, got the house painted, had some electrical issues fixed (ever see a literally burned out switch? I have photos!), installed a basement bathroom and replaced the water heater (which needs to be done every ten years… ours had not started to leak yet at more than a dozen years).
Then with cash we have paid for kitchen appliance repairs, replaced the washer and dryer, put in a side year patio, and are now are painting the walls (now that kids don’t draw on walls, it is time to cover up their artwork!). Next year I hope we can get the kitchen floors redone (I opposed having stupid wood floors in the kitchen! My advice… get linoleum or vinyl! Stay away from tile and wood!).
Houses don’t hold their value unless they are maintained.
Moses (#28) – The state of the auto market in the U.S. has led car companies to offer financing at rates considerably lower than banks will typically offer consumers on auto loans. My current loan from a Japanese maker is at 2.9%, and my neighbor just bought from an American maker at 0% over 5 years. These rates are better than current HELOCs even with the tax effects figured in.
Like HCN (#30), my wife and I did have a HELOC, which we used to replace our less-than-2-year-old HVAC system. (The original HVAC sub not only wouldn’t install the brand we asked for – somewhat understandable – but insisted on installing 10 SEER units rather than 16 SEER, and absolutely would not provide programmable thermostats; gave us the old dial ones with the mercury switches. When this system, which never worked well, began having major problems, we decided that instead of repairing it we’d go for what we wanted in the first place – installed by a different HVAC contractor, thank you very much.) The loan was for a 3-year term. We paid it off in a year.
Yes, HCN, it’s the Private Mortgage Insurance I was talking about avoiding if you’ve got sufficient equity. I certainly wouldn’t want to drop my homeowner’s policy!
Finally, re HCN’s bank insisting the construction loan had to be adjustable-rate: It took quite a bit of digging (no pun intended, honestly) to locate a bank willing to lock in a rate for the construction period and roll it unchanged into the mortgage. I can well believe that at certain times or in certain markets those terms would be impossible to find.
A house for a average working stiff costs more than an average working stiff will earn in a lifetime. Something’s got to be wrong.
Of course, the root of the problem is income inequality. The guys with money have so much of it that there’s nowhere to put it all, so it goes into housing and other “safe” investments, driving the prices up.
Actually, one recent article I read says that it isn’t “guys with money” – the housing price explosion in the 70s and 80s was actually caused by the rise of the 2-income household and the raising of the value of houses that were in areas convenient for both spouses to work. After a while of that kind of spiral, it became inevitable that ONLY 2-income households could buy a house in most city suburbs.
As for “wouldn’t dare?” – no, don’t take out an ARM, but a trad mortgage, but consider this: every dime you spend on interest for a mortgage is tax deductable (you’ll get between 1/4th and 1/3rd back, depending on bracket), and every dime you spend on principle is YOUR money, building equity so long as the property of the house itself remains stable. Paying off a 30 year mortgage means you have a house you can sell for raw cash when its time to retire into a smaller property.
Every dime you spend on rent becomes someone else’s money, exclusively. You’ll get the place to live now, but you’ll never get it back later.
I think it’s important to emphasize that the mortgage crisis wasn’t just about people getting suckered by dumb morgages. Interest-only loans are bad for banks as well: if housing prices go down, everone gets screwed. They made these bad loans because of enormous pressure from investors, who wanted mortage-backed securities to invest in.
I just finished two blog posts on how the mortgage crisis was a failure of the system as a whole, and not of individual banks and homeowners.
Realtors generally try to sell you as much house as they can. I had a good situation. My mortgage was from a special state program for first-time home buyers. It had a decent fixed rate, and a cap on the home price. That kept the realtor from escalating me into a more expensive home.
Joe (32), the factors that you mention regarding the choice between a mortgage and rent often suggest an advantage to mortgage, but not always.
If, for instance, a comprable house can be rented for less money, the difference can be invested for possibly even greater returns and a possible net gain. Or, if the duration of renting vs. buying is short enough, the advantage could go to renting. Or, if the perceived risk of homeowning is too great – such as if the resale value of housing is declining – the advantage could go to renting.
Quite simply, the choice could be mostly resolved with a Net Present Value calcuation, on a case-by-case basis. The NPV calculation will often go to the choice to buy, but for some realistic situations, the advantage goes to the choice to rent. When performed correctly, the NPV calculation would include the tax advantages, effects of inflation, and can even include the perceived risk factors.
I’m in the UK, and took out a 25-year Endowment Mortgage in 1996 to buy a £29 000 house (a two-up, two-down terrace, PVCu DG throughout, a few minutes’ walk from the city centre). The deposit was £1450, leaving £27 550 outstanding. This was on a 10-year fixed rate deal, fixed at 8.4%.
At the time, houses were cheap and mortgages were expensive: 8.4% didn’t seem so bad, prevailing variable rates were in excess of 6% and had used to have been in double figures.
Since then, without me even doing anything (I had gas central heating installed, but what that’s added is barely noticeable anymore), the value of my house has quadrupled. But also, MIRAS — Thatcher’s cunning plan to make buying cheaper than renting — has been abolished, and interest rates continued to plummet — affecting my endowment and necessitating for me to take out a second life policy. If I had not (1) found this job, (2) worked out that since no savings account would ever pay more interest than I was paying out on my mortgage therefore the best thing I could ever do with any spare money I had was make a repayment against my mortgage and (3) inherited £10 000 from my late Grandad, I’d be up to my backside in debt. As things stand, I can afford to pay off the capital early (though I’ll deliberately leave it short by a few pounds, just so the bank will hang on to the deeds till my 25 years are up — it’s cheaper than a safe deposit box and as long as I’ve always got that amount of money in the house, I needn’t fear the bailiffs!) and when the policy comes up, I’ll get the lot.
I feel really sorry for anyone looking to buy a house right now. Since the abolition of the rent tribunals, renting has become more expensive than buying, and “buy to let” carpet-baggers (why is it even legal to invest borrowed money?) have only made things worse.
This article is a bunch of FUD. Sure, it’s stupid to get an ARM or interest only loan if that’s the *only* way you can afford the payments.
For some people, these loans are great options. Greenspan himself said many Americans would have saved tons of money using ARMs.
HELOCs aren’t all bad – you fail to mention you get to write off the interest of these loans on your taxes; often this can make the slightly higher interest rates a really good deal in the end.
Brett:
I know that a lot of people consider Greenspan to be a genius. But personally, I think the guy is a despicable boot-licking jackass. And remember, he’s the guy who said that there was no housing bubble. So I don’t think that his opinion of things in the housing market should be treated as any kind of gospel truth.
And this is certainly not FUD. FUD is a business tactic to try to steer customers or potential customers away from a rival product. I’ve got no interest in this except in purely academic terms. I happen to think that *most* of the people who took ARMs took them for bad reasons.
And I think that HELOCs have, frequently, been mis-used to treat houses like ATMs. And “slightly higher” is a bad joke. HELOC rates are often double or triple the rates offered by things like car dealers. Like I said in the article: today the HELOC teaser rates are in the vicinity of 4.5%; car dealerships are offering 1.5-2% loans in my local newspaper. And that’s just the teaser rate! When I was writing this article, I looked at a bunch of HELOC contracts at various large lenders on the net – the HELOC interest rate ceilings ranged from 15 to 18 percent!
But the real HELOC problem is that so many lenders marketed HELOCs as “accessing your own money”. They made it sound like you weren’t *borrowing* money, even though you were.