Real Estate Mortgage Analysis - The Missing Component Of Wealth Manangement And Financial Planning

Why is this topic important to you and your clients?
Real estate and mortgage planning should be a key component in the wealth management services offered to your clients. Your client’s homestead and investment property are often some of the largest assets within their estate. Mortgages are almost always involved in a real estate portfolio. Many planners tend to focus on “investable” assets and overlook the real estate that may be the cornerstone of a person’s wealth leading to poor or nonexistent recommendations in this area. Mortgage planning should be involved in the planning process beginning with the pre-acquisition period, continuing during the holding period and culminating with the ultimate disposition of either the primary residence or investment property. With proper recommendations by the financial planner/wealth manager will come a stronger client relationship. Ultimately, you will end up with a happier client, more investable assets and probably more billable hours.

There are other benefits too. Your clients need the expertise that you can provide in this area. Even if you prefer not to do the following analysis, you should at least understand the talking points and suggest or coordinate a meeting with the appropriate tax and legal counsel. This paper will explain common mortgage products within the marketplace today. In addition there are real world applications and examples which you can use in your practice immediately.

What are the problems I need to think about?
The following are just a few of the questions you might want to consider. I don’t expect that you will have all of the answers. There also is no absolutely “right” answer to some of these questions. These are talking points that will probably involve other professionals on the financial management team. (1) Should a property be sold, gifted or refinanced to access the equity? (2) Is it better to die with a property in your client’s estate in order to get a step up in basis? Remember that gifting property involves the recipient acquiring the original basis. Selling property instead of 1031 exchanging it can subject the client to taxes that could have been avoided. Refinancing gives the client access to capital on a tax deferred basis-while the interest may or may not be deductible. (3) What type of loan options are available for my client today? (4) Are there any creditor protections that would be better afforded my client by having greater leverage on their home?

Let’s break down some of the basic considerations involving a primary residence. How long will the person own the home? How adverse to risk or change in payment will my client be over their projected holding time frame? The answers to these questions will give you the basis to begin exploring options. A common problem lies in mismatching the product to the holding period. Client goals can be maximized if you take the time to understand the products and then see how they fit into the client’s financial plan. For example, if the client has a 100% certainty that they will move out of their home in 7 years, you may want to look at a product that matches exactly that time frame, or create a hedge of 2-3 years either side of 7 years in case things change. Under this example there would be no reason to recommend a 30 year fixed mortgage unless the pricing was identical or cheaper than one of the other available shorter term products.

What mortgage products exist in the marketplace today and what problems do they solve for my clients?

First mortgage products today consist of 5 primary products and variations thereof. Most first mortgage products assume a thirty year amortization. It is what can happen over those thirty years that varies. Let’s make that assumption for this article. I will highlight 5 primary first mortgage products and mention one unique second mortgage option. All the options are available for your client’s primary homestead. They all may not be available for a second home or investment property. The mortgage note rate is generally .5-1% higher when financing anything other than a primary homestead.

1) FIXED RATE AMORTIZING MORTGAGES Your payment with this type of loan is made up of principal and interest. Each is a component of the payment. The entire mortgage will be paid off at the end of the thirty years. Following the rule of 78, the loan will be paid off with the last and final payment. The most common variation of this type of loan is the 30yr fixed mortgage, but there are 10yr, 15yr, and 20yr loans too. The main idea here is that these loans are fairly simple. They are meant for the risk adverse with a very long term prospective of being in their home.

2) ADJUSTABLE RATE MORTGAGES(ARM) With these loans the monthly principal and interest payment is based upon a rate and amortization period that is fixed for a period of time within the overall 30 year time frame. It could be six months to ten years. The overall loan term is again 30 years. After the initial fixed interest period of time, the loan payments adjust up or down, subject to a formula. This formula uses a fixed constant called a margin. A typical margin on today’s ARM’s will have a number of 2.5-3.5. The margin is a fixed number and is arbitrary and established by the investor when the loan is originated. The margin is added to a variable which is called an index. The most common index is either the average of the yield on 1 year treasury bills or the 6 month Libor index. The value of the index will change over time. There are many other indexes and versions of the two I just mentioned. Most ARM’s have “caps”. Caps prevent the margin + index rate from exceeding a certain limit. These caps adjust on the adjustment date which happens upon the end of the fixed interest period. After the initial adjustment the loan payment will adjust according to the formula either annually or more frequently. It all depends on the product and how often the adjustment is made. For example, a five year ARM might have a fixed rate of 5% for the first 5 years. The loan is a 30 year loan. After the first five years the rate is subject to change. The loan has caps of 6/2/6. The first number, six, refers to the initial cap adjustment after the first five years. This means the rate upon initial adjustment can’t exceed 11 % (calculated as the initial 5% rate plus the 6% capped rate). The next number, two, refers to the adjustment period every year after the first. A cap of two means the rate for every subsequent adjustment after the initial adjustment can’t exceed two percent over the previous rate. Lastly, the third number, six, refers to the lifetime adjustment. This means that anytime the loan payment is adjusted, regardless of the math, you can’t have a rate that exceeds six percent over the initial rate-which would be 11%. An ARM is best used to match a mortgage with a projected holding period. These can greatly enhance cash flow when looking at an investment property and should be considered as the preferred loan for short term holding periods.

3) HYBRID OPTION MORTGAGES These loans usually involve a combination of an interest only payment period of time after which the loan retains a fixed rate and amortizes itself over the remaining balance of 30 years. For example, a loan may allow an interest only payment period during the first 10 years of total 30 years. At the end of the first 10 years the remaining loan balance must be amortized fully over 20 years. The interest rate remains constant over the entire 30 years. These products are trying to combine the best features of both fixed and adjustable loans all rolled into one loan.

Within this category of loans there is a unique product called the Option ARM. It goes by other names too-Choice ARM, Pay Option ARM, etc. This type of loan generally allows repayment on a flexible basis that usually involves four repayment choices. Generally speaking, you can choose how you want to pay with the ability to change the payments each and every month. The mortgage payments can be interest only, negatively amortized based on a rate of 1-3%(depends on the loan and investor) with the deferred interest added to the back of the loan, 15 year amortization, or based on a 30 year amortization. The deferred interest (negative amortization) is the double edge sword of leverage. If the property is appreciating at a rate greater than the growth in the deferred interest the equity will exceed the amount of negative amortization. In the event that the market is flat or declining, the negatively amortized loan balance may exceed the value of the property. This is the “upside down” risk associated with one of these ARM’s. This type of loan is often used by speculators in highly appreciating areas or on second homes where people want a low payment today and are banking on appreciation occurring in the future. The key benefit to this loan is the payment flexibility, which can be very important if your cash flow is erratic or you want to achieve the lowest repayment rate. Normally, the fully indexed rate (margin plus index) will probably be higher than the prevailing fixed rate mortgage or traditional ARM. This type of loan may also carry a prepayment penalty. As mentioned previously, an ARM is best used to match a mortgage with a projected holding period. Option ARMs can greatly enhance cash flow if you utilize the minimum payment option which will result in negative amortization. Utilization of the minimum payment (negative amortization) will allow you to control a more expensive property than could be controlled with any of the other payment options.

4) INTEREST ONLY MORTGAGES These loans allow for only the accrued interest to be paid-no principal payment is required. Prepayment of principal may or may not be allowed without a corresponding penalty. This will depend on the product and program. Mortgage payments may “recast” to reflect any extra payments that are credited towards principal reduction. Terms and conditions of all these loans are lender and program specific. Most programs that allow for interest only have an interest only time period of anywhere from 6 months to 15 years. Buying a home with an interest only payment will allow you to purchase 15% more home for the same payment. Your mortgage becomes 15% larger than an amortizing 30 year loan with the same interest rate. This is yet another tool of leverage. The safety net with this loan is that while it doesn’t decline in balance, it doesn’t increase through deferred interest/negative amortization either.

5) REVERSE MORTGAGES Having recently been improved, these products are experiencing tremendous growth. Based on an expanding demographic, the aging population will demand these loans. In the future, I predict growth in the number of lenders offering these loans and a more diverse set of loan products being developed.

Consider these loans for clients who have a lot of equity locked up in their home but have a lower income than they desire. Reverse mortgages allow the homeowner to access their equity either by a lump sum, a line of credit available for draws at will or in a series of payments. In essence you are able to unlock equity and have the home generate an income back to the homeowner. This allows the senior to use “dead equity” for living expenses, home improvements, gifting or even investing. The loan qualifying criteria are that the person applying for the reverse mortgage must be over 62 years old and own his/her home. Other than age, the lender has NO credit or income criteria and repayment with interest occurs upon the sale of the property. The amount of equity available for this loan is determined by the borrower’s age. Suffice to say that the older you are the more equity/credit is available for the reverse mortgage. What I have found is that the largest objection has come from the heirs fearing they will lose their inheritance. Sad but true. Whose equity is it anyway and whose life should be improved because of it?

6) 125% SECOND MORTGAGES There are a few lenders that still write this type of mortgage. This loan allows the borrower to exceed 100% of the value of their property. The loan is a second mortgage that allows the total combined first and second mortgage loan balance to reach up to 125% of the value of the underlying property. This loan is unique in that the loan exceeds the value of the home. While the loan is collateralized against the home, the interest may not be deductible because the underlying security is worth less than the amount of the loan. There may be no equity at risk once you exceed 100% of it’s value. This can be a good product, especially if used for debt consolidation. For example, someone who has more consumer or business debt than equity left in their home might still have a need for further consolidation and a lower payment. Let’s assume your client happens to have non deductible credit card debt. Let’s assume the credit card debt is somewhat usurious, blending somewhere between 20-30% APR. A new 125% loan will be priced today with a rate tied to the prime lending interest rate. The loan rate will adjust by adding a margin to prime. In this example, prime is the index. The adjuster to prime depends on the amount of the loan and the credit score of the borrower. The pricing variables are credit score and loan to value. The higher the credit score and the lower the loan to value, the better the interest rate will become. Today you might find a typical 125% loan to be in the 10-17% range depending on the variables I just mentioned. You can do the math specific to your client’s situation and see how much he/she may be able to save by lowering his/her interest rate on non deductible debt.

Talk to me about the tax considerations.
There is also a change in our tax law that has just taken affect regarding mortgage insurance premium deductibility. In the past, borrowers would combine a first mortgage with a second mortgage if they wanted a combined mortgage balance greater than 80% of the properties value. For example, a property that someone wanted to finance at 100% loan to value might have been split between two loans. The loans might have a ratio of 80/20-split between a first and second mortgage. The blended rate provided a payment that often was better than one loan at 100% LTV that involved paying mortgage insurance, especially when you factor in the deductibility of the interest vs. the non deductibility of the mortgage insurance. Now, for loans closed in 2007, if the borrower’s adjusted gross income is under 100K, they will be able to deduct the mortgage insurance premium. This will change how you make recommendations. In this new environment, a loan with mortgage insurance could be better than a combination first and second mortgage without mortgage insurance.

Another question that may come up concerns the advantage or ability to deduct interest that accrues on the mortgage. For purposes of this article, let’s assume that interest is going to be deductible and that we have a loan amount that allows us to take the maximum deduction. Please go to www.irs.gov and download publication 936 “Home Mortgage Interest Deduction”. This will give you the rules on deducting first mortgage interest and home equity interest. You will want to know the rules as they pertain to your specific client’s situation.

The 1098 statements sent from lenders at the end of the year reports the interest paid on that mortgage over the previous year. Principal reduction is not deductible. In my opinion, reduction of principal becomes a forced savings plan with an after tax dollar. Yes, this helps build equity. But, is this the best use of your clients after tax capital? Should a client pay down the mortgage, thereby decreasing the loan balance and accelerating the loss of a mortgage interest rate deduction? Are there higher and better uses for the capital that fit into the clients desire for wealth accumulation? Let’s examine this further.

What about investment arbitrage? Show me the money!
Consider this. What if a client borrowed the maximum mortgage allowed and repaid it based on an “interest only” payment? This would give them the maximum interest deduction. Assuming that they can benefit from this, they will save on taxes. The amounts of capital that would have been used alternatively for the down payment or paid on principal reduction through a principal and interest mortgage payment on a traditionally amortizing loan can now be allocated to either an after-tax or pre-tax investment that might have better growth potential.

What if the client took the differential savings from an amortizing principal and interest payment vs. an interest only payment and instead increased their contribution to a tax deductible plan, such as their employer’s 401K plan? My premise is that they would accumulate more wealth. The problem for the majority of people is having too much month at the end of the money. Not everyone is able to make their house payment and maximize their retirement plan contributions. Switching to an interest only payment from an amortizing loan payment will keep the loan balance the same but increase the available cash in the budget. Another use for this payment savings would be the repayment of non deductible debt such as credit cards. Your job as their advisor will be to see that they understand the options and alternatives available. In order to do this you need to understand how the loan products work and where they are most appropriate.

We just discussed an example of the lost opportunity of incorrectly investing capital. You can explore this further with your client. Let’s look at another example. When you pay down a mortgage or prepay a mortgage, you are essentially earning the interest rate that you are paying off. Next I’d like you to compare this rate of return on an after tax benefit basis to an alternative investment on an after tax or before tax basis. Consider this. If the client desires to have their home paid off upon retirement, you may be able to demonstrate how they can accomplish their goal better using an appropriate asset allocation portfolio based upon some historical rates of return. If they were to fund their investment on a monthly basis with the cash savings from a refinance and/or interest only payment, they may find that not only will they be able to pay off their house at retirement but they will have additional dollars remaining.

“I’m an estate and retirement planner-why should I care”?
Initially we asked some questions about mortgages and real estate as they relate to estate planning. Sometimes people default to selling property as the only way to raise capital. Selling property will often accelerate the tax liability associated with any profit. It also takes away any further upside that may be available through appreciation. Proper guidance in this area could make you a hero. Borrowed money through a refinance is not taxable. You may find that a recommendation of a refinance will allow your client access to their capital without the associated taxes. Depending on the size of the estate and the estate tax laws in the future, you may also find it better to have your client die with highly appreciated investment property in their estate so that they can receive a step up in the tax basis upon death. This could be extremely useful for the real estate investor who has been acquiring and exchanging property over a long period of time. There are, of course, many different options including charitable gifting and setting up family limited partnerships. I just wanted to bring up the topic so that all options were explored. You may already do a Monte Carlo type analysis for your asset allocation of investable funds. I’m suggesting something similar with your client’s real estate holdings and mortgages. You should discuss scenarios and give some options.

You may or may not be aware of the change in taxation regarding the profit in a primary residence. Every two years, a married couple can exclude 500K in profit and a single person can exclude 250K in profit. This is replenishable and doesn’t require purchasing any replacement property. Capturing this profit tax free could be important in your client’s estate and taxation outlook. See IRS publication 523 “Selling Your Home” for details. Mortgage planning may be involved if your client is moving frequently. If a loan is going to exist for approximately 2-3 years you may want to recommend that they consider a low closing cost or no closing cost loan. These types of loans would be identical to what we have already discussed. The difference would be realized in a higher interest rate on the loan. The savings depend on the size of the loan and the closing costs, but a rough rule of thumb indicates that you will save money by taking on a higher interest rate with lower closing costs if your holding period is short. A simplified analysis can be done by looking at the differential in payments from a loan with closing costs as compared to the loan that has no closing costs. Take the difference between the payments of each loan scenario and divide that number into the closing costs proposed for the loan with the lower rate. The resultant number will be the months needed to equal/recover the full amount of closing costs. In most instances, you will see that it is a 3-5 year break even point. This means if you plan to keep the property for a time exceeding the break even point it would have been more advantageous to pay the closing costs associated with receiving the lower mortgage rate vs. not paying closing costs and accepting a higher mortgage rate.

Do you see the applications within your practice?
In summary, I hope you’ve seen the value in adding mortgage and real estate planning to your wealth management practice. You don’t need to be the expert, but you do need to recognize the problems in order to help guide your clients towards a solution. As financial planners and wealth managers our job is more than crunching numbers and setting up asset allocation models with various investments. You can’t prescribe a client solution until you’ve done a complete diagnosis. We are our client’s “financial doctor” identifying problems and offering options and solutions that meet the client’s objectives and fit their comfort level.