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.

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?

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