Monday, December 31, 2012

The Mortgage Interest Deduction



Happy New Year! Sometime in the very near future, our Congress is going to start picking apart our current tax structure. This examination of allowable deductions is not part of the New Year’s Eve wrangling that is going on as I write this. But, for at least a month, I have been getting frantic emails from Realtor® organizations that the sacred “Mortgage Interest Deduction” is an endangered species that must be protected. (Pardon the mixed metaphor. The hyperbole around this subject has no subtlety.)
I asked my financial planner about whether he took these dire warnings seriously. He said that the deduction will not go away. “It is a political third rail.” No one is going to let that deduction disappear. Then, I asked my tax accountant. He wrote, “Attempting to remove the mortgage deduction would be politically difficult, (if not suicidal).  However, attempting to cap all deductions would be much easier to sell unless the nation's charities could successfully combat the notion.” The guys I depend on for information about taxes both think this deduction is both necessary and untouchable.
When real estate came up at a party, I mentioned the deduction and got a similar reaction. People see questioning the mortgage interest deduction is equal to saying home ownership is unnecessary to the economy. The deduction, they say, “is huge!” So, it seems that tax-related professionals and the home-owning public see this deduction as very important and a political hot potato.
I asked my tax accountant to explain the deduction, he wrote:

On the most basic level, the mortgage deduction may reduce your taxable income on a dollar to dollar level.  I say may because the amount of the mortgage deduction (plus state tax and other deductions) has to be quantified against the standard deduction. Reducing your taxable income reduces the amount of taxes you pay. 
Usually the mortgage deduction is the vehicle that allows middle class families to itemize their deductions (and thus begin to fulfill the American dream).  The important consideration on this subject to remember is that "the higher your personal tax rate the more significant the mortgage deduction becomes".
For many people, they could not afford their house or condo if their tax burden wasn't being reduced by the mortgage interest deduction.  This is part of why you are getting pressure from Realtors®. 

I think differently from most of my real estate agent peers. My first thought about this deduction is that the emphasis on it is way out of date. Houses are not the tax shelter that they used to be. The reason: low interest rates.
Mortgage interest rates have been as high as eighteen percent in my lifetime. But, that’s not so normal. Normal is more like seven to nine percent. It’s just that we have been spoiled in the past fifteen or so years, when mortgage interest rates have been hanging well below six percent for most of this generation of house buyers. 

Let’s do a little math:
Suppose you have a mortgage for $300,000. Your interest payments are front-loaded, so you pay far more interest and far less principal in the earlier years. The tax deduction is on the interest, so you get bigger deductions in the beginning when you are paying interest more and principal less.
If your interest rate is a typical seven percent, your interest in the first year will be roughly $1750 a month – that’s $21,000 in the first year. In year five, it is roughly $1640 a month – that’s $19,680. In year ten, it goes to $1490 – that’s $17,880. At year fifteen, it is down to $1275 -- $15,300 annual deduction. These figures are significant tax shelters.
With current interest rates around three percent for 30-year mortgages, the picture is very different. Interest in the first year will be roughly $750 a month – that’s $9,000 in the first year. In year five, it is roughly $660 a month – that’s $7,920. In year ten, it goes to $560 – that’s $6,720. At year fifteen, it is down to $450 -- $5,400 annual deduction. It’s a tax shelter, but not like it was when interest rates were higher.

I am not jumping up and down screaming that the mortgage interest deduction is vital to the housing economy. I am being a rebel without a cause?







Thursday, December 27, 2012

Easy ways to waste your heating dollar



Today, I saved my tenants a hundred or more dollars. This is how it happened: A couple of weeks ago, one of my tenants reported that his window sash didn’t stay up. I asked my tenants to check all their windows so that I could get all the repairs done at once. Please open and close and lock all your windows. Let me know which ones don’t work.
When I came in today, almost all the windows were unlocked. I locked them. Thus, I decreased the cold air flow significantly. My tenants are like most people. Most people don’t know that these windows are not really sealed until they are locked.  

On the way out, I noticed they put their boot mat over the air intake for their furnace. This is also something most people don’t know about, until it happens to them. By covering the intake, the furnace has to work harder to get air in. The intake grate is usually bigger than the grates that the heat comes out of. They are often in hallway (which make them tempting for places to put boots.) If the furnace is blowing and the grate is not getting hot, it could be an intake grate. (It could also be a duct that is blocked off.) Blocking this grate decreases the efficiency, at least, and can cause worse problems if the air is cut off too much for too long.
This happened before. That was with the old furnace and old tenants. They had a rubberized mat over the whole intake grate. That caused the furnace to stop working. The HVAC guy showed me what they were doing and tuned up the furnace while he was here.  Problem solved. Until today.
Another side-effect of putting your boots on the intake grate is that, on rare occasions, it can make your house smell like au de roasted boot. I didn’t smell this first-hand -- so it may be an urban legend -- however, this is the story I heard:
There was a house that had a bad smell. Sort of briny. The family cleaned everything, but the smell persisted. Eventually, they went to get their heating ducts cleaned. The duct cleaning crew told them that they shouldn’t store sneakers on the intake grate. That was probably to source of the smell. They cleaned the ducts anyway. Afterwards, the smell was gone.

The takeaways:
Lock vinyl windows in the winter for better efficiency.
Keep mats, furniture, and shoes off the intake ducts for furnaces. The machine needs air flow to function properly.

Wednesday, December 26, 2012

Is creative financing a thing of the past?

After revisiting Elizabeth Warren's writing, I return to the topic of lending. There are ways to borrow for a house with less than 20% down. You can, but should you?


Some people seem to have never heard of the mortgage meltdown of 2007. They show up in my practice  (usually on the phone) upset and unhappy because they can’t borrow as much money as they thought they could, and the &^%*# lender wants so much documentation. They ask whether I have a reasonable lender for them to talk to.

Today, I write to the people who just walked into the world of real estate and are wondering why lending is the way it is:
In the book, The Big Short, Michael Lewis explains the details of the conversion of mortgage notes into a bond commodity. At some point in the Bubble years, the way that the bonds were rated became strongly weighted on the credit score of the borrower and less weighted on the borrower’s income and ability to repay. This created a market for mortgages with borrowers who had high credit scores. Their ability to repay the mortgage didn’t much matter. When everything collapsed around this questionable valuation of notes, the banking industry tightened their standards.

Some think they went overboard. Have they gone overboard, or are they simply protecting their investor’s assets? The truth about lending lives somewhere in between the free-for-all of the mid 00s and the tightening that started in 2007.

Yes, today there are mortgage programs for people with less than 20 percent down. There are programs with as little at 3 percent down. There are several programs available. Two examples are FHA and Mass Housing. The requirements for each of these low down payment loans vary. For example: Mass Housing has income restrictions. All of these programs have credit score requirements as well as some other underwriting requirements. Check with your lender for details. Mass housing has just introduced a 3 percent down payment loan program with no MI (mortgage insurance). Rates on all these programs are at typical market rate.

Other “creative financing” is still available, too. For example, there are combo loans available. This allows the home buyer purchasing a high end property to get a conventional fixed rate mortgage instead of a jumbo rate mortgage (which is higher.) It is done by getting two loans on the property -- a 1st and a 2nd mortgage. This way, neither loan will surpass the jumbo loan limit.

To do any of this fancy footwork, you need to have excellent credit and steady employment. You also need to be buying a property that isn’t distressed in some way (low owner-occupied condo complex, very poor condition.) Special programs, like FHA, scrutinize the condition of a property and frequently fail something that needs work. (I’ve had sellers need to repaint a garage to pass FHA muster.)

Some of you think the only way to regain sane pricing is to require 20 percent down. Yet would-be buyers have been frustrated by the immensity of a 20 percent down payment at these high prices. Are you one of those would-be buyers?

Thursday, December 20, 2012

Is Debt Immoral?



When I got to the chapter “The Myth of the Immoral Debtor” in The Two Income Trap,  I was reminded of an exchange between A.B-G. and Markus at BREN.  A.B-G.  wrote: 

“We may lose a little in the first year or two, but if we can make the payments and we're there for the long haul--then what's the problem?”

Markus responded:

“No problem--as long as you have a written warrantee [sic] signed by God Himself guaranteeing that you will not lose your job, be transferred, get sick or have any major unexpected household emergencies over the next five years.”

Elizabeth Warren and Amelia Warren Tyagi explain that most people who get deeply into debt are not profligate. Many get into trouble because of emergencies. They then gave examples of who survives financial setback. They wrote:

“Of course, not every job loss, divorce, or illness ends in the bankruptcy courts. Some families collapse under the weight of too many bills and not enough income, but many families do not…” 


They tell the story of a couple they call Jamal and Trish Dupree. Jamal, at forty, had a heart attack. He lost five months of work. Trish lost income, too, because she took time off to be helpful to Jamal’s recovery. Health insurance exclusions and deductions added up. Yet they were a couple who did not end up bankrupt.
How did they make it? Luck and planning:  Luck, in that nothing else happened while they were vulnerable. Luck, in that Jamal had a job to go back to. Luck, in that Trish was able to get overtime pay after the crisis was over. Planning, in that they had health insurance. (But, health insurance is not nearly enough; 240,000 families with continuous health insurance file for bankruptcy every year.) The big advantage was that the Duprees had long-term disability insurance. Even so, they drained their long-term savings and did without essential things for a time.

Nothing is sure in this life. If you bought a house, ever, what made you sure enough to take the leap?  Do you feel more financially secure when you own your house? Do you need a warranty signed by God Himself?

Reprinted from BREN, March, 2010


Wednesday, December 19, 2012

Financial literacy and financial health



Ms Warren and Ms Warren Tyagi in The Two Income Trap wisely advise families to prepare for emergencies ahead of time. I am thinking of copying the chapter “The Financial Fire Drill” and giving it to my clients before they start house hunting. They pose three questions:

1. Can your family survive for six months without one of the incomes you rely on?
2. Can you downshift the fixed expenses?
3. What is your emergency back-up plan?

Rent or mortgage is usually the family’s biggest fixed cost. Since mortgage is almost invariably higher than rent here, would-be home buyers need to think about their fixed costs and how to prepare to pay them. Therefore holding the mortgage payment to something you can handle is key.

I would like to get specific about how to think about your mortgage payment.
The “front” ratio for a loan is your real estate monthly payment in relation to your gross adjusted income. A prudent limit is no more than 28 percent of your income that can be used for your housing expense. I advise my clients not to fudge it beyond that level.

Let’s keep it simple:
If a couple earns $100,000 gross adjusted income, their mortgage payment is capped at $28,000 a year, or $2,333 a month. That’s the whole payment: principal, interest, tax and insurance.  Most of the time, my would-be clients are clueless about the weight of property taxes. They can borrow $350,000 for less than $2000 in principal and interest. Fine. Property insurance is likely to be under $200 a month. Great. But taxes in that price range can get as high as $600 a month. Especially in the suburbs where there is more land on the parcel.

OK, scale back. Since a cheaper house will have lower property tax, on average, at $100,000 gross adjusted income, the prudent loan amount comes in at about $280,000, assuming a $500 a month tax bill. Where taxes are lower, say $300 a month,  that figure goes up to about $315,000.

In this market, that doesn’t buy a family home in a toney suburb. If both members of the couple are working full time to earn that $100,000, can you have a back-up plan that would work? Unlikely.

Depending on two incomes at maximum mortgage level is a bad idea.

When mortgages were calculated on a single income -- in those Father Knows Best days -- couples could overcome a set-back by sending Mom to work. I think the mortgage rules should be scaled accordingly, with a lower ratio if two incomes are being counted (maybe 20-25 percent.) Even if the rules aren’t changed, I try to convince my clients to scale themselves back so they have fixed costs that they can handle.

I feel like a lone wolf crying in the wilderness about this. At least The Two Income Trap authors take it seriously.

Reprinted from BREN, March 2010.