The Refinance Trap

When Larry wrote about his misunderstanding of refinance math, I dusted off an older entry to explain the trap he fell into. There are costs for refinancing mortgage loans:

Cost of the refinancing service: even if you get a “no points, not closing cost” loan, you are paying for it somehow. Sometimes the rate is higher than a mortgage with more fees. Sometimes the fees are added into your principal.

Time: suppose you refinance into a new loan after three years, you can be hurting yourself by setting the clock back. If you go from a 30-year product to another 30-year product, you are adding years to your payments. Are you really ahead? Most of the time, no. Also, interest is front-loaded, so your lender takes more interest from you in the first years.

Here’s some quick math:
(This is without taking any cash back.)
If you borrowed $325,000 at 6.125 percent, the principal and interest is $1975. Three years later, you reduce your rate to 5.125 percent, and you borrow what is due on your existing loan – about $312,000. The principal and interest is now $1699. Wow, you are saving nearly $275 a month. (That's $99,000 over the life of the loan.)

But, you are paying your loan for an additional three years. Add the 36 more payments of $1699; that’s $61,164. That cuts your savings some, doesn't it?

In the current rate environment, if you were going from 5 percent to 3.5 percent for a 30-year mortgage, it would look like this:

If you borrowed $325,000 at 5 percent, the principal and interest is $1745. Three years later, you reduce your rate to 3.5 percent, and you borrow what is due on your existing loan – about $309,400. The principal and interest is now $1390. Wow, you are saving about $355 a month. (That's $127,800 over the life of the loan.) Add the 36 more payments of $1390; that’s $50,040 less that you are saving.

When borrowers refinanced with cash back, they frequently were not ahead if they looked at the added payments. If you are further along on your mortgage than three years, your savings get slimmer and slimmer, if you have to set your borrowing time back to the 30-year mark. 

Real estate advice in the current refinance boom: If you can afford to shorten the term of your loan, you will be in much better shape. Otherwise, don’t rush into a low rate without looking at the whole picture. Do the math for yourself before going ahead with a mortgage refinance.

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?

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

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.