Approximately 65% of the licensed mortgage brokers in business today have less than 5 years of experience. These loan originators were taught how to get people qualified under the most profitable program available. These inexperienced originators were focused on the transaction today, not the client down the road.
The easiest sales were Adjustable Rate Mortgages (ARMs) with profits hidden in the margin, especially the Cash-flow Option ARMs, offering a payment rate as low as 1%.
When a loan rate adjusts, it adjusts based on the Index (a benchmark which reflects current market rates, i.e. the One Year Treasury Bill, or the London Interbank Offer Rate (LIBOR), or the Prime Rate (the Fed Funds Rate plus 3%). To this benchmark, one adds the Margin- that is, the Profit Margin for the Lender/Bank. Margins typically range from 2.25 to 2.75, but often can be as high as 3.25 or more.
When distracted by a Payment Rate of 1%, the typical borrower can easily forget that the real rate of interest is that Index Rate (LIBOR today is around 5.34%) plus the Margin could result in a real rate between 7.54% and 8.59%. Originators make money selling the closed loans to Lenders. Lenders make more money when the loan has a higher Margin, therefore they pay more to the originator to encourage higher margins.
This abuse has created an unfortunate backlash against good loans improperly used. A Harris Interactive poll of 2,383 U.S. adults released last month indicated the a hugh majority don't trust mortgage advertising and most do not like ARMs or Interest Only loans.
Indeed, a renewal of "Depression Era Thinking" is occurring that will cost the average borrower $25,000 over a five year period when compared with proper debt and equity management.
This "Depression Era Thinking" is the practice of prepayment of loan principal and shorter fixed term loans. Prior generations were taught that owning one's home free of any debt would protect the ownership and value of the home because early mortgages were callable- the bank could simply call the loan because they needed the cash, even if the borrower had a perfect payment history. This is no longer possible, but this nonetheless started the practices. Like the tradition of cutting off the ends off a roast passed down through the generations, a grand-daughter preparing the family dinner one night asked how it effected the roast's flavor. The grandmother recalled that she actually did that because her old oven was too small for it to fit the whole roast- it had nothing to do with the present day rationale for the practice.
The $25,000 mistake that most borrowers make is in prepaying their mortgage. If one were to put down $20,000 and buy a home for $100,000, and realize no appreciation for 5 years, and then sell the home for $100,000, they would walk away with $20,000 (less the cost of sale). The $20,000 had no rate of return.
If the same borrower bought for $100,000, with $20,000 down, and realized 5% appreciation, they would walk away with $47,628. The appreciation of $27,628, plus their original $20,000, which again had no rate of return. In other words the rate of appreciation has nothing to do with whether the property has a mortgage, and additional payments to principal earn no rate of return. In fact, the build up of equity makes the home more attractive to the bank in foreclosure, and gives the bank less reason to work with a borrower in distress. It is easy to conclude then that prepayments actually reduce the bank's risk while increasing the borrower's risk.
The prepayments are plowed into an "investment" that has no rate of return, can lose value and is not liquid. Not the kind of "investment" that a prudent saver would use!
Consider two brothers with identical income and the same amount of savings, $100,000. One buys a $500,000 home with a 15 year fixed loan at 5.875% APR using all of his savings for a 20% down payment. His payment is $3,348, but after tax deductions feels like $2,983. He also adds an extra $200 per month to prepay the loan.
His brother also buys a $500,000 home, but with only 5% down, he takes a 6.375% Interest Only 30 year loan. His monthly payment is $2,523, which after tax deductions feels like $1,690.He leaves the remaining $75,000 in a safe, guaranteed, money-making Investment Account earning 6%. Every month he sends the monthly payment savings difference of $1,293 plus the same extra $200 his brother does into his Investment Account.
Five years later, the first brother has received $33,796 in tax savings, but has no Investment Account.
The second brother has received $49,955 in tax savings and his Investment Account has grown to $205,330. This strategy will ultimately allow the brother to pay off his loan more quickly than the first brother anyway.
Now, which would you rather be if you suddenly lost your job, or became disabled. Both brothers have equity in their homes, but neither could qualify for a loan to extract it! Brother Two has a significant cash reserve to sustain him through difficult times.
The facts are that the average first-time homebuyer owns a home for an average 3 years; a move-up buyer averages 7 years; and the average life of a mortgage loan is 5 years. For the average borrower, a 30 year loan is a waste of interest, and the principal paid over these time frames is much less than the lost investment opportunity.
The answer lies in the fact that the best loan is the lowest rate on the right loan. These are rarely short term ARMs with monthly, 6-month, or even 1 year adjustment periods. Many Clients can be well served by intermediate term hybrid ARMs with guaranteed 5, 7, and 10 year fixed periods with annual adjustments after the fixed period, and with Interest Only options for the right Clients. Rates could cycle lower during the term or the savings will more than offset the cost of a refinance if the Client wants to extend the term or separate appreciation equity from the home.
The best loan scenario will match the Clients goals for how long they want to own the home, how aggressively they want to save, and will match income trends and life cycle changes (marriage, kids, college, retirement). This is best accomplished by a Certified Mortgage Planner with several years of experience, who uses a regular process of annual review to assure the plan continues to meet the client's goals.
