Sushi Money

*** Update ***  Apparently the Treasury Secretary’s plan does NOT include plans for current homeowners to refinance their loans.  So while many of us may sit on mortgage loans at greater than 6% or 7%, this plan would allow neighbors to move in to their house with a new mortgage loan with much lower payments.   This seems wrong… it may be a temporary fix, but how will it help millions of current homeowners who are having trouble making payments on their current mortgage loans? 

This week we found out we’re officially in a recession, and have been since around December, 2007.  The market has been wallowing at multi-year lows and layoffs have been increasing.  In light of so many economic challenges, it’s hard to see any bright spots that can move us forward.  But what about a lower mortgage payment?  Would a couple hundred extra bucks each month really make a difference, or help people purchase a house?

For many of us, it just might.  That’s the focus area of the government recently- mortgage loans and the possibility that a U.S. sponsored wave of mortgage activity and refinancing could bolster both the housing market and the economy as a whole. 

“The plan, which is in the development stage, would temporarily use the clout of mortgage giants Fannie Mae and Freddie Mac to encourage banks to lend at rates as low as 4.5%, more than a full point lower than prevailing rates for standard 30-year fixed-rate mortgages.”

“The plan is very similar to an idea floated in October by R. Glenn Hubbard and Christopher Mayer, academics at Columbia University’s Business School. “I think a program to substantially bring down rates for homebuyers would be an incredibly valuable program, and I think it captures a real part of solving what has been an incredibly challenging dislocation in the credit markets,” Mr. Mayer said in an interview. He estimated the idea under consideration could quickly help 1.5 million to 2.5 million people buy homes, giving a major boost to the housing market and broader economy.”

Certainly people would still need to qualify for the mortgage and have decent credit ratings to do so.  But a 30-year loan at 4.5% ?  Sign me up… not only would the monthly payment for many of us decrease, we would be able to focus more on reducing debt levels and increasing consumer spending.  *** Not for current homeowners! ***

“…Treasury Secretary Henry Paulson views lowering mortgage rates as key to fixing the housing crisis; hence the mortgage-security-buying program announced last week.  The most important thing we can do to mitigate foreclosures and progress through the housing correction,” Mr. Paulson said in a speech Monday, “is to reduce the cost of mortgage finance, so more families can afford to buy a home and so homeowners can refinance into more affordable mortgages.”

I have to agree (for once) with Secretary Paulson- making homeownership more affordable for credit-worthy families sounds like a great idea.  As long as we aren’t handing out loans to people that can’t repay them… hopefully we’ve learned that lesson already. 

Just for kicks I ran the numbers on the difference between the monthly payment for a 6.5% 30 year fixed-rate loan, and the same loan at 4.5%.  These numbers are for principal and interest only and don’t include taxes or insurance payments:

• 6.5% 30-year fixed-rate loan:   Monthly payment of $1,137.72
• 4.5% 30-year fixed-rate loan:   Monthly payment of $ 912.03

Okay, so we save about $225 bucks a month with the new mortgage. That’s not chump-change, and lots of folks can qualify for a 4.5% loan that would not otherwise qualify for a 6.5% loan.  Even refinancing is a great idea as long as we’re planning to stay in that house for a few years or more.   *** Not for current homeowners! ***

A Rush Into Refinancing may be just what the country needs right now however. But the new plan may not even include this option!  

I thought that’s what the Treasury Secretary was aiming for, and how they believe it can help dig out the country from the current housing mess.  Get more people into homes sitting empty out there, and make those monthly payments more affordable for all of us.  Good idea, but if they exclude current homeowners, then I don’t see how it helps the economy en masse.

By the way, what’s even more important over the long term on that interest rate scenario?  Think about how much interest you would be saving. 

• 6.5% 30-year fixed-rate loan:  Total interest paid $229,587
• 4.5% 30-year fixed-rate loan:  Total interest paid $148,336

That lower rate loan would save us over $81,000 dollars!!!

Sounds pretty good to me- that would pay for a kitchen and bath remodel, or even a few new cars over the lifetime of that mortgage loan. 

So is it time to buy that house you’ve been looking for?  Time to wade into real estate again?  Well, the real estate debate continues, and there are many opinions.   Even if a lot of us can think of several really good real estate deals out there, the money’s just not there right now.  And that’s part of the problem- with the stock market down, real income down, and folks losing their jobs, we’re running out of people that can qualify to purchase real estate.  

Maybe, just maybe, lower long term mortgage rates will help us climb out of this whirlpool?  Hard to say- that whirlpool is also a downward spiral… and deflation can take a long time to work out of.  Just ask the Japanese.

***Update: October 2008***  With the financial crisis in full-swing in the second half of 2008, many see bailing out homeowners as a necessity in order to stabilize the housing markets.  As the government bails out financial institutions and takes ownership positions, it may only make sense to stabilize the mortgage market through a structured approach to helping refinance troubled loans for homeowners.  In the middle of the crisis it’s time for action, and what may have not been considered previously may now be necessary.  It will be interesting to look back years from now to see the effects of these economic choices. 

So the FDIC Chairman is advocating freezing ARM rates for mortgage borrowers who are in trouble?  Wow…  I have to say I have very mixed feelings about this proposition.  Especially since the percentage of mortgage borrowers in trouble is very small compared to the mortgage spectrum across the nation.  What signal are we sending to lenders and borrowers if we travel down this road?

“Keep it at the starter rate. Convert it into a fixed rate. Make it permanent. And get on with it,” Federal Deposit Insurance Corp. Chairman Sheila Bair said in prepared remarks at an investor’s conference.

   In many ways that does not seem fair at all to millions of homeowners and mortgage holders that prudently shopped for their loan and took out more appropriate loan terms, most likely with higher interest rates.  For example, let’s say borrower #1 found a really big house for $450,000 (that they shouldn’t have been purchasing), and took out an ARM with a low teaser rate for 1-3 years.  Now they’re in trouble making payments. 

Borrower #2 bought a house at the same time, but realized they couldn’t afford such a large mortgage, and didn’t want to take the risk of an ARM with potentially higher rates in the future.  They would have loved that $450,000 house… but they could only afford a $300,000 house with a higher fixed rate loan.  They continue to make their payments at the higher fixed rate, and are somewhat mystified that those who got low rate teaser ARM loans might now be rewarded and get their loans converted to fixed rate loans, maybe even at lower rates?  

So what kind of incentive is that for people to make prudent decisions in the future?  What does that say to future potential homeowners and mortgage borrowers?   I think it says to do whatever the heck you want and you don’t have to worry about the financial consequences.  Which is absolutely wrong of course.

 I think people who have made prudent decisions have a right to wonder about this.  Some of the least appropriate lending decisions and home buying decisions have been made by people who misrepresented both income and their ability to repay a loan.  Perhaps unintentionally for many people as well.  But now that real estate has dropped in value for many homeowners, why is it in the nation’s best interest to reward those who put themselves in this situation?  

     I’ve come full circle on mortgage loans.  I used to be a fan of Adjustable Rate Mortgages, their flexibility and diverse product makeup.  And they can be a useful tool for specific situations.  But I’ve evolved to being a fixed-rate kind of guy. Why?  Because it’s just simpler over time, and probably costs less over the long run.  If you’re shopping for a new mortgage loan, and your choice is an ARM however, I strongly recommend you find an ARM tied to a U.S. Treasury index rather than a LIBOR or other index.  Why?  Because for quite some time now, the LIBOR interest rates have been moving in the opposite direction from Treasuries… meaning LIBOR has headed up while Treasuries have remained stable and begun trending down.  What does this mean to you?  In a nutshell, when (not if) your ARM resets… that is when the ARM initial rate period ends, and the new interest rate takes effect, a LIBOR ARM is going to reset upwards by more than a Treasury index based ARM will.  

     For example, let’s say you have a 5/1 ARM.  That means your intitial interest rate is fixed for the first 5 years, and then can reset once each year thereafter.  Each reset period is usually “capped” at a certain limit, such as a maximum of 2% per annual reset period, or with some loans the first reset is capped at 6% for the first reset period, and then 2% thereafter.  If you have had a 5/1 LIBOR ARM for the past 4-5 years (probably at a very low rate of 3%-4% plus a 2.5% margin) you need to be prepared for the reset that will increase your mortgage interest rate, especially with LIBOR rates currently around 5.2%.  Add the 2.5% margin to the LIBOR index and the new rate is 7.7%!.   For those with ARMS tied to the one-year Constant Maturity Treasury (CMT or TCM) index, their loan reset will result in a lower mortgage payment than the LIBOR reset because the 1-year TCM is about 4.3%.  Add in the 2.5% margin and the new rate is only 6.8%.

     Here’s an example- remember this only shows the Principal and Interest portion of the monthly payment, since every tax, insurance and PMI situation is different.  The mortgage payment includes PITI and PMI, which means Principal (cost of the loan), Interest (rate), Taxes (on your home), Insurance (for your home) and Private Mortgage Insurance (if your down payment/home equity is less than 20%). The following example is for illustration only, and may not consider specifics of various ARM products:

     So in the example above, the LIBOR ARM mortgage payment was higher because LIBOR interest rates are higher for the LIBOR index.  We know interest rates change all the time… the 1-year Constant Maturity Treasury index is lower right now, it’s a simple as that (and maybe after next week it will be even lower)?    And in the example above, the ARM payment resets are only for the next 12 months… in another year they will reset once again.  Will they reset higher or lower?  No one really knows… that’s the ARM game, and each year after the initial period the mortgage rate is going to change in one direction or another, and sometimes dramatically.   Here’s a look at the last few weeks comparing the 1-year Treasury index to the LIBOR index.  The rates are not always that different, and often they are very close, although it seems to me that the “London Inter-Bank Offered Rate” (LIBOR) tends to be higher over time.  In 2007 however, they have been drifting further apart for a host of economic reasons, monetary policy, the Dollar versus the Euro, etc.  It pays to know what Index your ARM is based on:

     And there are many different index values used for ARMS such as COFI, CODI, COSI, LIBOR, CMT, etc, etc.  Here’s a chart comparing the COFI, 1-year Treasury and LIBOR rates:

     We don’t know the future, but we can make thoughtful and careful analysis about our income and debt.  If you’re considering an ARM, think about what happens if interest rates go higher over time… the mortgage payment is going higher as well- can your income afford an increase?  How much?  We have also seen recently that it is not always so simple to refinance a loan, especially if housing prices are falling nationwide.  That’s the bind a lot of people are finding themselves in recently.  And yes, ARM loans have a “maximum interest rate cap” typically around 11% or 12%.  But can you imagine making mortgage payments at those rates?  We probably won’t see those rates of course… but they did in the early 1980’s, and I’m not willing to mortgage my future, and my house, to the risk of higher rates over time and increasing mortgage payments.  If a person has really solid documented income or other sources of personal wealth, they can choose to play the ARM game and just refinance when desired.  The bottom line these days is that ARM rates are not much different than 30-year fixed rates.  So why choose an ARM over a fixed rate loan?  Well, if you can get a lower ARM rate, and  can handle the increased mortgage payment if rates go up, and can refinance when desired based on  your income and wealth, and can sell your home if you can’t refinance, and can deal with watching interest rates over time… then maybe an ARM is for you.  

      I have had ARM loans before, and they served the purpose… but did I truly understand what I was getting into at the time?  Not the first time, but yes for the second time.  My favorite was a 5/1 ARM for two and half years, at 4.3%, and I then sold the home and moved. That ARM saved us a lot of money in interest payments over the short term.  But it was a concern for me because I knew interest rates were going up.  If I had not sold the home, I would have needed to refinance the loan, probably to a 30-year fixed rate mortgage.   And that’s where we are now… trying to keep it simple with the knowledge that our monthly mortgage payment will remain the same. It’s just easier to not worry about payments that might change over time, or what interest rates are doing. 

Remember!  Every Adjustable Rate Mortgage can be different, using a different index, rates, margins, adjustment caps and maximum caps.   Closely examine any ARM loan documents to ensure you understand the loan terms.   

For more information about ARMS and other types of home loans, here is a list of references.  I really like Jack Guttentag’s website as The Mortgage Professor.  He provides a plain-language, no-nonsense approach to a host of information about mortgages, real estate, many tools and calculators and an excellent mistakes to avoid section.

Types of Mortgage Loans – The Mortgage Professor

Adjustable Rate Mortgage Calculator – The Mortgage Professor

Adjustable Rate Mortgages – The Federal Reserve

Adjustable Rate Mortgages – Wikipedia

     What did I miss?

     President Bush held a press conference discussing mortgage problems in the nation, and outlined a few initiatives he would like to see to help homeowners who are struggling to keep up with mortgage payments.  Realistically, few things will change right away, but the President’s focus does help bring attention to the problems and put it where it belongs- in the lap of Congress.  The legislative branch needs to get to work and overhaul various aspects of the lending laws, as well as modernizing the Federal Housing Administration.

“It’s not the government’s job to bail out speculators or those who made the decision to buy a home they knew they could never afford,” Bush said in the Rose Garden. “Yet there are many American homeowners who could get through this difficult time with a little flexibility from their lenders or a little help from their government.”

     Will lenders work with homeowners more now?  Maybe…  The President also cited the tax code as being a burden when a homeowner may receive “forgiveness” of a portion of their debt or mortgage balance.  The tax code does treat debt “forgiveness” as income, and it would be fully taxed in the same year.  Although I applaud possible changes to the tax code in certain situations, I have two concerns or doubts about this as being effective:

         1.  Why should an individual or family that is struggling to pay their mortgage receive any greater tax benefit than a similar individual or family that is paying their mortgage on time?  In other words, if two individuals or families (in a similar tax bracket) are paying for a similar mortgage amount, what happens when one family chooses to run up their debt and credit cards, buy new cars,  take out an adjustable rate mortgage on a house they can’t afford… and when they struggle to keep up with house payments their lender helps them out, forgives part of their loan, and Uncle Sam gives them a tax-free (or reduced tax) gift?  Now let’s say the other family made more prudent decisions, were careful with their debt and credit cards, managed their expenses carefully, didn’t take out an ARM (or if they did are paying it on time), and because of their wonderful financial management discipline… do they get a tax break?  Nope.   Does that seem fair?  Nope.  Nobody ever said the tax code was fair however.   But tell me, how is this an incentive to to foster financial discipline and positive money management for homeowners?  It’s not… it’s just a political hot-potato that will receive some level of attention.  

     But honestly- in good faith, I’m glad our government is focusing on ways to help people who really need help. Many times we don’t know the reasons an individual or family is struggling… it could be for some totally different reason like a death in the family, etc.   That is important, and we can do more.  Some homeowner or tax advocates might say it could be treated like capital losses or gains.  We’ll see…

      2.  More realistically perhaps, how many lenders are really going to “forgive” $20,000 of mortgage debt someone owes?!  I don’t really know how often this has happened… maybe they do.  More often I believe lenders will establish a “workout agreement” of some type where the homeowner’s payment is reduced or modified for certain time period, or the loan is re-negotiated or refinanced.  I really don’t think many lenders will be “forgiving” debt outright.  I could be wrong, but I suspect most will become creative in the way they can keep people on the hook for the debt they do owe.  And morally or ethically perhaps, if we owe a debt, then we should repay it.  If we cannot because of life-changing circumstances, then bankruptcy is another option to help someone start over. 

    All in all I’m glad that housing and mortgage woes are getting national attention.  In so many ways it speaks to the confidence and psychology that we all share for how the economy, and the country, are doing.  Our economy is chugging along pretty well considering housing and a few other areas, but if the mortgage woes continue… guess what?  Consumer spending will dive and so will the rest of the economy.  I don’t know… what do you think?  I’m guessing housing still has 2-3 years before it recovers.  If the banks and finanical institutions can get the lending and money-flow thing figured out, we should be fine. 

     In a not too surprising move, the major Democratic Presidential candidates have begun to make political hay out of the mortgage and subprime lending issues.   This article discusses how Senators Dodd, Clinton, Edwards and Obama have all made statements or introduced legislation to try and “remedy” the mortgage lending system.  Why is this not surprising?  Because quite simply it speaks of more government regulation and intrusion into individual and business owners lives in America.  Increased government regulation is often the Democrats answer for “fixing” perceived problems in society.  Unfortunately I think they are making too many assumptions, most of which involve the belief that mortgage brokers are primarily responsible for the problems we are facing with subprime loans.  First of all, the subprime lending mess is only a tiny fraction of all mortgage lending in this country.  Of that tiny fraction, only a portion of borrowers are defaulting on their loans.  There is no question that lending standards have been too lax for too many years, and that loans were made available to people who shouldn’t have been approved for them. What about a borrowers responsibility? If there was outright fraud and deceit in the loan processing, then absolutely… go after those lenders.  But do we need to “overhaul” the mortgage lending industry simply because of lax lending standards and a few predatory lenders? 

    The article cited also shows how it’s not only the lending industry that is at fault here.  Wall Street and the financial industry have embraced these loan products as investments.  Much of the subprime mess is related to hedge fund investments gone bad also, and that’s why we’re seeing such market volatility and panic among investors around the world.  So overhauling the mortgage lending industry will solve these problems too?  I don’t disagree with all of the ideas or calls for action by our political leaders.  Senator Dodd’s ideas for example involve tightening underwriting standards on loans and reducing the “no doc” or “low doc” loans that many borrowers have been presented with.  I’m all for improving lending practices and providing increased clarity for potential borrowers.  But I disagree strongly with his call for requiring lenders to escrow for taxes and insurance.  So the government wants to become the “big parent” and ensure that borrowers pay their taxes and insurance on time?  I don’t know about you, but I don’t need the government telling me how to manage my money.  With my current mortgage for example, I pay my own taxes and insurance payments, and that flexibility is very important to me.  Instead of putting my money in an escrow account, I can keep it in my own savings account earning interest.  I can plan my insurance and tax payments for the optimal time of year based on my savings and household expenditures.  With escrow accounts, one often has to put in far more than necessary, and well in advance, simply because the lender requires it and federal regulation says they can do so.  I don’t want the government telling me I have to do that.  How can I pay my taxes and insurance myself?  Because I have a good credit rating.  With an excellent credit score, you can often request from your lender that you pay your taxes and insurance yourself.  Some lenders or loan products will not allow this, but many do.  It pays to shop around and ask first. 

     Senator Dodd also wants to get rid of all prepayment penalties on loans.  At first glance this sounds like a great idea… I cannot stand prepayment penalties and will never take out a loan that has one.  But again, why should the government decide for the financial institution how they should do business?  There are valid reasons for loans with prepayment penalties, most often involving loans with really good (low) interest rates.  In exchange for a really low rate, a mortgage company might include a prepayment clause to help make up some of the difference on the interest rate, etc.  It depends on the loan product, and it may also be tied to credit standards and risk. These are businesses, and they are not in business to give money away.  Some people want the choice of a specific loan product, even if it does have a prepayment penalty.  I don’t, but if someone else does, that’s their choice.  I don’t think the government should have a hand in it. 

     Ultimately, I believe with more government regulation we will see increased costs and interest rates for borrowers on average.  Why?  Because there is less flexibility and choice for consumers, and less incentive for financial institutions to develop anarray of lending and investment products that satisfies both borrowers and lenders needs, as well as attracting investors (aka Wall Street) to provide the liquidity that makes the world go round.   Less choice is not a good thing in terms of business and saving money.  We want competition and choice, and with less government intrusion we achieve those goals. 

     That being said, I’m all for improving mortgage lending to help improve consumer choice and opportunity as well as requiring fair practices by lenders.  Ambiguous perhaps, but Senator Edwards for example has talked about banning “certain fees” (I’d like to see what fees he’s talking about), and establishing uniform broker licensing requirements with a national database for disciplinary infractions.  Hmmm… who’s going to pay for that “national database”?  Yep… taxpayers and borrowers.  I like the idea of uniform broker licensing, but believe the States should have the primary authority in that regard.  After all, it is at the State and local level that people take out mortgages for homes… we live in communities and often those communities have unique needs and cultural approaches to conducting business.   Don’t we have State requirements for licensing and lending anyway?  

   Finally, I have to make a comment about the choices and actions that we, as borrowers, make in the lending process.  No one forces us to sign on the dotted line.  The problem for too many people is that we are not smart enough or educated enough to know what we are signing and how to manage our financial lives.  Increased clarity and knowledge about the mortgage loan process is always a good thing.  When someone takes out a loan, they don’t do so with the intent to default or give up their home in foreclosure.  That is a traumatic and life-changing event that no one desires.  Many financial institutions are currently working with customers who have problems making payments to ensure they keep their homes and continue paying on their loans.  The bank certainly doesn’t want our homes and a defaulted loan.  But as borrowers we are legally and financially obligated to pay on that loan.  We must do our homework and make our financial decisions rationally based on our income and lifestyle needs.  Don’t buy more house than you can afford.  If you can’t afford a 30-year fixed rate loan for the house you want to purchase, then you can’t afford an adjustable rate mortgage for that same house… especially down the road.   Maybe not always true- but it’s a good rule of thumb.  How can the financial world function without legal requirements for borrowing and lending?  It can’t.  I’m also a strong advocate for financial literacy education.  Many states are now including financial management education as a requirement for high school graduation.  It’s about time… and we need to do more.  That’s something I’d like to see our political leaders talking about.