Wealth Clarity Blog

If you think getting a loan secured by your home, either a home equity or first mortgage is a piece of cake it might be time to think again.

Over the past several months I have run into several client scenarios where the assumption was that getting mortgage financing for a new home, or to refinance an older mortgage, was a no-brainer. In two recent cases loans were denied where there was significant income (i.e. north of $250,000 per year) and plenty of liquid assets (i.e. well over $2 million); one client is a senior executive at a major technology company.

You might be saying, huh?

Well, in the brave new world of banking, it is more prevalent than you might believe. To get the bottom of the story and why it is happening with increased frequency, I contacted my good friend Robert Wuflestad, who is a very experienced mortgage banker, for some answers.

So, Robert, what is going on right now in the banking world that’s causing so many wealth creators grief?

The simple answer to this question is the industry is still in recovery. The fed is propping up conforming and government loans, but the mortgage crisis virtually wiped out the secondary market for Jumbo mortgages and non-conforming mortgages. Without this secondary market, there is little choice or competition and borrowers are limited to the institutions that have money to lend. Since many of these institutions are still trying to recover from their own problems, they are only willing to lend if they are certain there is little risk AND they are going to make a profit. This gets rather silly at times especially with the big banks because they can be extremely rigid in what they will allow. Competition is emerging and there are some attractive programs available through institutions other than the big national banks, but borrowers must still be able to document income and assets, common sense has been abandoned. Credit scoring can be challenging and you must manage this prior to entering the market.

It appears to me that high levels of assets, even if they are liquid, no longer matter. Is that right?

To get the best rates, if you have the required minimum of assets, generally it doesn’t matter how much more you have. You still must meet the required income, credit and property requirements. The idea of “common sense” guidelines have died, may it RIP.

There are a few regional banks that will lend on the strength of the borrower, but rates may be a bit higher, but even they have to be concerned about new regulations designed to protect borrowers from predatory lending and putting borrowers in position where their income cannot support their debt.

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I am a fan of country music.

The big draw for me is that country songs generally tell a story.  In fact, I believe this is the reason why country music is so popular, crossing over into mainstream pop and other music genres.  And let’s face it, everyone likes a good story.

The problem is that too many real-life stories don’t get told–or,  maybe better stated, stop being told.

I am finding more frequently that many wealth creators are quick to limit their life story, those specific desires and dreams, until some future event occurs that will magically free them to continue on.

One particular country song by Jamey Johnson, titled “In Color,” touches on this idea.  It tells the story of how life is lived in color, and not in shades of gray, or black and white.

Using snapshots as the example, the song attempts to express that there are really two stories for each life experience:  the static one we see in a black and white photo, and the vivid, colorful, passion-filled one that really embodies the story behind the picture.

Your Life Story

Put in the context of wealth creators, there are very specific, in-living-color plans, dreams, and hopes for your life.  They are things you think about; maybe not often, and maybe only in those quiet moments on the plane, driving home from work or in the solitude of a family trip with the kids asleep in the backseat.  But they are there and they are in color.

This was true of a woman I met in Oregon recently, who shared with me the clear five-year vision for her life.  Unfortunately, she owned three real estate properties that didn’t fit into that vision, and in fact, they were blocking her from pursuing the life she wanted.

I asked her, “What are you doing today to have confidence that your five-year vision will become a reality?”  (This process was discussed in a previous entry.)

Answer: She was going to wait for the real estate market to recover, potentially 2 – 3 years, before pursuing her dreams.

What if the real estate market doesn’t come back?

What if this is the new normal for the real estate market?

What if prices continue to decline?

And, isn’t everyone else thinking the same thing i.e. let’s plan to sell our real estate when prices move higher?

She was faced with several choices:

• Sell the properties at a loss and move quickly towards her future vision
• Sell one of the properties now and set a timetable for selling the others during the next eighteen months
• Delay her dream while waiting for the markets to recover

Getting a nudge to start seeking information from a local real estate broker allowed for new alternatives and opportunities to surface, and gave her a sense of excitement.

The decision about what to do would become clearer once she started moving toward her goal.

It’s easy to think about all the reasons why we shouldn’t do something; I believe most people are wired to think about things this way.  I surely don’t want to minimize the benefits of waiting, patience, and timing—all key attributes to a successful strategy.

However, in many cases, action is the missing ingredient in achieving the life you desire.

Is it time to take action?

In my last entry, “Home Mortgage or No Mortgage,” I discussed some of the common strategies for using mortgage financing, and the four keys to smart debt decision-making.

There is one additional key that makes sense to add: 

            Run the numbers before you refinance.

This was important to a recent client case that involved a 5/1 adjustable rate mortgage (ARM).  This type of loan structure has been very popular over the past decade because of the generally low entry level interest rate (fixed for the first 5 years), which converts to a variable interest rate based on an index (e.g. one-year Treasury bills), for the remaining term of the loan. 

One of the risks of this product is the following: Depending on when the initial fixed rate period ends, you might face variable interest rates that are substantially higher than when you started.  With the real possibility of higher interest rates in the future, partially caused by fiscal and monetary stimulus, refinancing now seemed to make sense for my client. 

Fixed-Rate Term Ends

My client (call him Steve) had reached the five-year mark back in April, which stopped the fixed rate of 4.5 percent (historically a wonderful interest rate).  Interestingly, because rates had dropped significantly the past several years, the first-year adjustment reduced the rate even further to 3.5 percent, and locked that in for another year.    

Further, he was a quick payer, and wanted to pay-down or pay-off the principal balance quickly, possibly in 10 – 15 years. 

Dilemma:  Refinance or Not?

The choice was to either (1) refinance to a new mortgage with an interest rate of roughly 5 percent, or (2) keep the low one-year rate (3.5 percent) and take his chances on interest rates rising in the future.

Surprisingly, the standard loan document (i.e. Fannie Mae) held some clues to the outcome:  namely the common provisions related to ARM’s.

• There is a ceiling on how high the rate can rise.  In Steve’s case it was 9.5 percent. 
• There is a cap on how much the rate can adjust each year.  Steve’s loan document said two percent. 
• At each adjustment date the loan is recast.  (Note:  Recasting a loan means that you calculate the new payment by using the remaining balance and years to maturity (in this case 25 years), and the new interest rate, and solve for the payment.  It is somewhat akin to refinancing but without the cost and associated paperwork.)

15-Year Mortgage Alternative

This type of loan structure matched Steve’s objective of paying off the mortgage in about 15 years and suggested a monthly payment of about $3,000.

When comparing the 15-year mortgage to the ARM Steve currently had, and considering the maximum interest rate on the ARM of 9.5 percent, the calculated monthly payments of both alternatives were about the same.  

The benefits of running the numbers:

• Steve was able to avoid the cost and hassle of going through a refinance but still meet his objectives of shortening the loan term and defusing the perceived interest rate risk.
• He was able to create his own 15-year mortgage by making an increased payment on his ARM equal to the difference between his current ARM and the 15-year mortgage payment.    
• Because the ARM loan is recast (see note above) each year, these higher monthly ARM payments actually have the affect of paying off the mortgage faster than 15 years. 
• Steve can make additional larger principal payments throughout the year, reducing the outstanding balance even faster, and will still be reflected in the payment calculation at the time of loan recasting.
• If interest rates stay lower and don’t rise, the rate on the ARM is lower than the 15-year mortgage alternative, saving Steve money.

Having mortgage debt on a personal residence is an interesting paradox for many wealth creators.  No matter how much risk you might currently be exposed to via business or investments, the home, and mortgage financing, create a tension that is caused by: 

• The family home is a naturally supercharged emotional topic
• The differences in how each person was raised and what role money, and specifically debt, played in your history
• Your investment experience and comfort with debt 

3 common strategies for debt 

In general, wealth creators fall into three camps as it relates to having a home mortgage.  

1. Debt free:  These individuals want to pay cash for their home—and generally other major purchases as well. 
2. Quick payers:  They will use financing to purchase a home but will make large principal payments to shorten the life of the mortgage. They also tend to choose shorter-term mortgage products like 15 year mortgages. Note:  these people tend to struggle when an expensive home purchase or home development project is funded with debt, even if only for a short period of time.  The size of the debt balance fosters increased stress levels, ultimately becoming the impetus to rapidly reducing the outstanding balance.
3. Debt analyzer:  These people view home mortgage debt as a choice, in essence, an investment decision.  Because they have ability to be debt free (as is the case with most wealth creators), it really comes down to whether they believe their other investment assets will return more than the after-tax cost of the mortgage.   

What is the after-tax cost of a mortgage?  

This is most critical to the debt analyzer.  Because the interest paid on a home mortgage can potentially be an income tax deduction, the after-tax cost of the mortgage is generally a rate lower than the stated mortgage interest rate.       

For example, an individual with a 5% mortgage, in the 35% federal marginal income tax bracket, and able to utilize all of the mortgage deduction, would have roughly a 3.25% after-tax mortgage rate. 

 mortgage rate X (multiplied by) 1 minus the marginal income tax rate

This becomes the bogie or hurdle rate you could use to assess your mortgage decision. In other words, if you have investments that are returning more than the hurdle rate (3.25% in our example) you might decide to place a mortgage on the property. 

To the contrary, and applicable in this environment of very low cash returns, you might choose to take low yielding cash—essentially zero—and pay down the higher cost mortgage debt. 

            In both cases, it boils down to an investment allocation decision.

Four keys to smart mortgage decision-making 

1. Find a mortgage broker that is able to review various options, not just sell product.  This will require running scenarios and alternatives to make sure the debt solution is customized to your needs.  (I will be writing more about this shortly.) 
2. Understand what your emotional tolerance is for debt, and how it might differ from your spouse.  What you learned about money from your parents (your money history) will have a huge impact on your debt strategy.   
3. Know your payback plan.  If you are going to use debt financing for your home, explore the various strategies that will optimize your payback needs.  This may require the combination of various strategies, for example margin debt, line of credit, and traditional mortgage.  It will also require an understanding of what assets will be used for the planned principal payments. 
4. Be cognizant of the many specific tax considerations regarding mortgage financing; tax deduction phase-outs and debt balance limits to name a few. Make sure to review any mortgage with your CPA before you sign loan documents or take action. 

With two kids already off to college and one safely stashed with friends, my wife and I were invited to northern Idaho for a Labor Day weekend getaway.

Our friends' Idaho getaway provides not only a great weekend escape, but a place to cultivate family memories and values.

Aside from the six-hour car ride from Seattle, we were excited to be guests at this beautiful home on the south shore of Priest Lake, one of three pristine mountainous lakes in Idaho’s panhandle.

For our host family, this home and property provide a year-round gathering place for three generations of family and their friends.

Depending on the season, there’s abundant hiking, snowmobiling, water skiing, family dinners on the patio, stories around the fire pit, lots of laughter and games—all happening at this lakeside retreat.

Your family may already have a place like this so you may fully understand the power and benefits of creating this type of family experience.

The location or aesthetic features aren’t the key.  In fact, in the case of our Idaho friends, the little red cabin next door is the true humble beginning of their family story.

The important question is this:  Does your family have that one special place?

Why is this important?

In short, it is a tangible way for your family legacy to take shape and develop.

No matter where the ”place” is, it becomes the conduit to share family history, honor older generations, build new family memories, reinforce family values and beliefs, and provide a consistent place over time where family and close friends can gather.

There is no doubt that special places like this one in Idaho require vision, even, …courage to create.  But they can pay rich dividends to your family for generations to come.