As home loans get harder to obtain, the number of renters increases, and so will rent

Come October 2011, buyers’ purchasing power is will reduce even further:

• The FNMA (Fannie Mae) loan limit will be reduced from $729,000 to $625,500, pushing more buyers into jumbo loans for which there are fewer lenders and consolidators.

• Jumbo loans require 6-12 months of reserves, which is more than FNMA requires.

• Interest rates will likely rise, making qualifying for a loan even harder.

• Mortgage insurance for FHA loans will increase by 30% in April 2011.

• Credit scores are on the decline.

• As home equity has vanished, buyers who want bigger homes will not have the equity from the sale of their current home to put toward the new purchase, which will likely require a 30% down payment.

What does this means?  More people staying in their homes, more people unable to qualify for a loan, more people renting instead of buying.  This is all true before we get to the conversation of the recurring suggestions in Congress that the mortgage interest deduction should be reduced or eliminated.  There are times when it’s good to be a landlord. This is one of them.  And, yes, we do investment property loans, too.  Give us a call.

But interest rates are so low!

Yes, I know.  But interest rates don’t matter. Stop chasing sexy interest rates while forsaking good financial decision-making.

I’ll also wager that the same familial financial advice-givers that told you to get the 30-year fixed-rate mortgage also told you not to spend money on depreciating assets, like a fancy car.  They say that it’s not financially prudent to throw a lot of money at something that you don’t have for very long and is ultimately disposable. (This particular piece of advice I agree with, by the way, but I will also concede that fancy cars are fun to drive and are a nice luxury item to purchase with disposable income.)

Please, please, please see the inconsistencies in these two positions. 

My clients who are in adjustable rate mortgages are saving a truckload of money right now, both in their mortgage balances, payments, and lack of refinancing fees.  Their interest rates are in the 3’s or lower.  For all of you who just read that sentence and are secretly and smugly thinking about how smart you are for getting a fixed-rate mortgage at 4.5% because interest rates are going up, I ask you these questions:  How do you know and when will it happen?  Those questions are important.

Look at this math:  The longer a rate is fixed, the higher the interest rate.  The longer the term of the mortgage, the more the bank makes.  A 30-year fixed-rate mortgage at 4.5% has an interest charge that is 82% of the original loan amount.  In the first five years, you pay 25% of the total interest charge.  In most cases, the loan balance isn’t cut in half until after year 20.  No kidding.  Here’s another fun math factoid of mine: A $500K loan, fixed at 3% has a payment of $2108.  In five years, the loan balance is $445K.  The same $500K loan, fixed at 6% has a payment of $2998.  In five years, the balance is $465K (yes, $20K higher after making $53K more in payments).

What does this mean?  If you’re going to take out a home loan for 10 years or less, the adjustable rate mortgage mostly likely puts you money ahead.  You’ll pay less overall and chip away at the principal faster such that in higher interest-rate years, you’ll be paying a higher interest rate but on a lower loan amount.  It still makes sense to take the adjustable, even in a low interest-rate environment. In fact, I would argue, especially so in a low interest-rate environment.

The 30-year fixed-rate loan is the Cadillac of mortgages—big, expensive, and probably disposed of in 10 years or less through sale or refinance.  If you won’t buy a fancy car, why are you buying a fancy mortgage?  I know, it is humbling to think about.  Your familial financial advice-givers mean well.  They do.  Sometimes they just don’t know what they don’t know.  Now you do.

What does this mean and why do you care?

Warning:  Remember, this is a blog.  The goal here is to present the big picture on sometimes complicated subjects. By design, I oversimplify.

First, it will likely mean higher rates.  Mortgage-backed securities have bond-like quality.  They sell with a price (what they cost) and a yield (what they earn).  The law of supply and demand drives price and yield.  Sorry to haunt you with Economics 101. If prices are high, the yield goes down (which generally drives people to sell).  If prices are low, yield is high (driving people to buy).  If the Fed stops buying those securities and there is no other buyer, prices will drop to attract those buyers, yields will go up as a result, and those yields are directly correlated to mortgage interest rates, which means—you guessed it—that interest rates on mortgages have to go up as well.  Got it?

Second, understand that just a few years ago, the Fed owned no MBSs.  None.  By March, it will own $1.5 trillion.  Trillion with a T.  This means that $1.5T is now in the marketplace.  Too much money in the marketplace can mean greater inflation (too much money chasing the same amount of goods).  Now, so far, we haven’t seen greater inflation.  It’s the Fed’s job to keep that in check.  Someone also has to pay for these purchases, meaning that the American taxpayer is likely going to have to pony up money to cover it.  That may mean higher taxes—higher income taxes, higher capital gains taxes, and the list goes on.

We can’t predict the future, but we can do our best to anticipate what might be coming around the blind curves in the road.  This might be a good time to consider refinancing into that 30-year fixed-rate loan if you haven’t already.  This might be a good time to consider a loan modification.  This might be a good time to consider retirements and education funding plans that provide a tax-free component.