Managing Your Mortgage

Part I:  Mortgage Basics

Professor Matthew Spiegel

July 26, 2006

As nearly everybody knows a house is the biggest investment most families will ever make.  On the other side of that cliché should be appended the statement that the mortgage to buy the house is the biggest single loan most families will every have to deal with.  So, it is quite important to deal with it well.

The question people typically want to answer is, “which mortgage is ‘right’ for me.”  Many articles point out, quite correctly, that the answer depends on your current financial situation, how long you expect to live in the house, and what you expect your family’s income to look like down the road.  Unfortunately, that is only half of the story.  The other half has to do with how much risk you can afford to take and in order to answer that question you need to know what the risks and rewards actually are.

Part I of this article (which you are reading now) goes over the various options, their features, and tax consequences.  Part II examines the historical interest rate data to let you better determine which of the available mortgages you should take out.

Mortgage Terms

You cannot decide what mortgage to take out if you cannot speak the language.  You need to know what the various elements of a mortgage are called, and what they mean for your finances and taxes.  As we will see the meaning of some terms may not be quite what you expect.

Interest Rate

When looking at a mortgage loan the place to start is with the most misleading term of all:  the “interest rate.”  When you see an interest rate of 6% that does not mean the annual interest rate on your loan is 6%.  Instead, it says that the monthly interest rate on your loan is 6%/12 or .5%.  Thus, if last month you owed $200,000 then at the start of this month you owe $200,000×1.005 or $201,000.  The actual annual interest rate on your loan is about 6.17%.  In general, the interest rate on your loan is higher than the number you will see on the loan offer. 

Loan offers and documents also include a number called the “Annual Percentage Rate” or APR for short.  On a mortgage document this number is essentially meaningless.  You not only can ignore it, you should. Furthermore, do not let anybody talk you into thinking that the way to compare mortgages is by their APR.  On other documents the APR sometimes (but not always) provides you with the loan’s true annual interest rate.  Alas, a mortgage document is not one of them.

The one good thing about making a mortgage interest payment is that it generally lowers your income tax bill.  Most families can subtract their mortgage interest payments during the year when calculating your federal (and in most cases) state taxes.  There is however one major exception.  You can only deduct the interest paid on the first million dollars of principal. So, if you have a $1.25 million mortgage only 1/1.25 or 80% of your interest payments will tax deductible.  For second mortgages only the interest paid on the principal amount up to $100,000 is deductible.  If you are reading this and you are not in one of coastal states you probably think this limitation is no limitation at all.  But, I can assure you that for those living in states like California, or cities like New York these limits mean something!

Points or “Pre-Paid Interest”

Points are simply an additional fixed cost you pay to take out the loan and must be paid when you receive the funds.  One point equals one percent of the loan value.  Thus, if you take out a $200,000 mortgage with 3 points you would have to pay the bank an additional $200,000×.03 or $6,000 to get the loan.  Unlike other charges by the lender to take out a mortgage, the bank will exchange points for a lower monthly interest rate.  That is why it is sometimes called pre-paid interest.  For reasons that will become clear later on, if you are good at managing your finances my advice is to nearly always avoid paying points.

The only complication involving points is their tax treatment.  If you are buying a house the mortgage points are tax deductible in the year you pay them.  That is good, since you have to pay out the money today and you get your deduction in the same year.  On the other hand, if you are refinancing your mortgage the points have to be “amortized” over the life of the loan (typically 30 years).  In our example, that would mean that you can deduct $6,000/30 or $200 a year from you income when calculating your taxes for the next 30 years.  (Note, though you paid the $6,000 when you received the loan.  So while the tax deduction is spread out over time the money you paid in points is not.)  If you move, or refinance before the 30 years are up you would then be able to deduct the remaining “balance.”  In this case the balance is $6,000 minus the amount you have already taken against your taxes.  Why are points treated differently when they do or do not accompany a home purchase?  I have no idea.  Go ask a politician.

Closing Costs

When you go to sign the loan documents you typically have to pay a fee called the loan’s closing costs to obtain the mortgage.  Ostensibly, they cover the bank’s costs for extending your loan.  The listed items often included things like an appraisal fee, a document preparation fee, and an administration fee to name just a few.  Among other things you will notice is that the “closing costs” are almost all associated with the normal costs of running a bank, and making loans.  These costs are entirely under the bank’s control and there is little you can do to reduce or increase them.  The worst part is that typically you will not know exactly what your closing costs will be prior to the day you sign the mortgage contract.  Yes, you will receive a “good faith estimate” when you are initially approved for the loan.   But that is practically worthless as the actual costs can vary significantly from the quoted amount. 

One way to avoid the whole closing cost issue is to find a “no closing cost loan.”  Often these are available from mortgage brokers if you take out a large enough mortgage.  The reason for this is that the brokers receive a commission based on the size of the loan they bring to the lender.  But, it takes a broker no more time to handle a large mortgage than a small one.  Thus, if yours is large enough, you can often get the brokers to indirectly rebate back to you a part of their commission by having them cover the closing costs.

If you have to pay closing costs on your loan then my advice would be to see if you can at least find a lender with a guaranteed fee program.  For example, www.ditech.com has been advertising mortgages where closing costs are fixed at $395.  (Alpha Investment Opportunities is not affiliated in any way with ditech.com, and this is not a general endorsement of their products.)  With a bit of effort you can find other lenders with similar programs. 

Since the government views closing costs as a fee you are not allowed to deduct them from your taxes.  This brings us to one of the times where you might want to pay points, which are tax deductible.  Mortgage brokers can often be convinced to “trade” points for closing costs.  That is if you agree to pay more in points they will give you a no closing cost loan. Essentially this changes the name of the fee from “closing costs” to “points” and thereby also changes the fee’s tax treatment.  This costs the broker and lender nothing and can save you hundreds dollars.  At the very least be sure to ask your lender about making the swap if you have not already arranged an no closing cost loan.

Title Insurance

Title insurance is essentially another closing cost.  It is also a total rip off.  Standard title insurance pays off your mortgage if it turns out there is something wrong with the (surprise) title.  For example, if a long lost treaty with a local Native American tribe deeded your lot to them then title insurance will pay off your mortgage.  The lost value of your house beyond that is not covered, unless you purchase a supplemental policy.  While my example may seem far fetched it is not too far off the mark.  Consumer Federation of America’s Director of Insurance J. Robert Hunter testified before a Congressional Committee that his survey of the literature indicated that less than 5% of every title insurance premium dollar is paid out in claims.  Not sure how high this is?  For cars the rate is closer to 80%.  Before a title insurance agent sends me an angry email let me debunk the standard counter argument the industry makes.  The title insurance industry says that the insurance premium primarily pays to research the title to make sure that it is in fact good.  Thus, the “insurance” really covers checking to make sure you will not have any problems in the future.  As a result costs are high (to pay for the checking) while payouts are low (since the checks work).  This is all very nice but accounts for a miniscule fraction of the title insurance’s cost.

If you have a mortgage you have no choice but to take out title insurance.  Worse, you have to buy a new policy every time you refinance.  If title insurance was really about covering the cost of checking for the title then certainly when you refinance the old policy would carry over.  At the very least it should now be possible to get a new policy at no cost since the title has already been checked.  Even more can be saved when you consider that the previous owner probably had title insurance as well.  Thus, the firm underwrote that policy (and thus already checked the title) should be willing to sell you a new policy at a greatly reduced cost.  None of this happens.  You have to pay for a new policy every single time the mortgage changes, whether through the home’s sale or because you refinanced the mortgage.

If you are not taking out a mortgage you can save yourself a lot of money by not taking out title insurance.  If you have any qualms about your home’s title you can either do the search yourself at the local town hall.  Better yet, find out if the home’s previous owner had a mortgage.  If he did then he had title insurance and thus a search has already indicated the title is currently clear.  Of course, if that long lost treaty shows up you are out of luck.  Personally, though, that is a risk I am willing to take.

Fixed Rate Loans

Fixed rate loans have a fixed monthly payment set to a level that allows you to pay off the loan in a given amount of time, the mortgage’s term.  A standard fixed rate mortgage has a term of 30 years.  This means that if you make your monthly payments on time then in 30 years the mortgage will be fully paid off.  You can also get fixed rate loans with terms of 15, 40, and in some cases 50 years, but the vast majority are for 30 years.

To the degree that people compare fixed rate loans they tend to look at those with either a 15 or 30 term.  If you borrow $200,000 to buy a house and want to pay it off in 15 years rather than 30, then naturally your monthly payments will have to be higher.  On the other hand you will make them for only half as long.

One often touted advantage of a fixed rate loan is that you know that your required payments will never increase.  With these loans even if interest rates go up your payments will not.  Better yet if interest rates go down you can typically refinance the loan and reduce your payments.  Refinancing, basically, means taking out a new mortgage with a lower interest rate to pay off the original higher rate mortgage. 

Whether you should go for a long or short term mortgage depends on your ability to manage your finances.  As with other issues of mortgage selection we will handle this in Part II of this article.

Adjustable Rate Loans (ARM)

Adjustable rate loans typically go by the acronym ARM.  They come with two numbers and you will see them advertised as x/y ARMs.  Here the x tells you how long until the mortgage rate first adjusts, and the y how frequently it will adjust thereafter.  Thus, a 3/1 ARM means the rate is fixed for three years and then adjusts once a year thereafter.  While there are ARMs with various combinations of terms most are either of the 1/1, 3/1, 5/1, or 7/1 variety.

The initial rate on your loan (the x period) will depend on the rate being offered by your lender.  After the initial period ends the mortgage will then adjust based on some current interest rate that varies by region.   In the northeast, for example, the rate will typically adjust to 2.75% above the current one year treasury rate.  (The rate the federal government pays for borrowing money for one year.)  When taking out an ARM you should pay close attention to the mechanism that determines how the rate resets.  Your goal, naturally, should be to find a loan that will have the lowest rate after the initial period ends.  To know which loan will provide this you will need to read each lender’s documents.

Interest Only, Option, Balloon, and Other Mortgages

If you need help either setting up an investment plan or advice concerning how much risk is associated with various choices feel free to contact us Alpha Investment Opportunities.

© Matthew Spiegel