THE BASIS POINT

Actively Managing Your Mortgage, Part 1

 

It was not long ago that most home loans were the same, simple structure. A fixed rate along with an amortization schedule of 15 or 30 years. But in the past couple market cycles, and especially in the past five years, home loans have gotten a lot more sophisticated to meet the expanding objectives of homeowners.

People move around more for their careers, buy homes at younger ages, and have added real estate to their overall investment strategies. The lending industry has evolved to keep pace with these objectives, and this is why you have heard us stress the importance of “active mortgage management.” We have compared it to securities investing, where you can actively manage your stock and bond portfolios to try to beat the market, or you can seek more conservative returns with investments that simply track the broader market.

The same logic goes for mortgages. “Tracking the broader market” with your loan would mean taking out a 30-year fixed mortgage – you’d just set it and forget it. But what if you know you’re not going to own the home for 30 years? Or what if monthly cash flow is your top priority? In either case, then, you’re losing money by paying the rate premium for that 30-year loan. It makes more financial sense to actively manage your mortgage.

Below are a few examples of active mortgage management in a market context.

Active Management: June 2002 to June 2004
Let’s say you were actively managing your mortgage four years ago when rates were dropping to all-time lows. Traditional 30-year mortgages and intermediate-term ARMs were appealing at that time, but many borrowers were beating these loans by about 1% to 1.5% with 1 or 6-month adjustable LIBOR loans. LIBOR is a loan index that is more volatile than many other indices, meaning it drops faster in a down market and rises faster in an up market.

So the active mortgage strategy this time in 2002 was to get into a LIBOR loan to capture that extra 1% to 1.5% (average) drop in rates that you couldn’t get with any other loan type. On a $500,000 loan, this translated into about $10,000-$15,000 in savings over 2 years, compared to a 5-year ARM or a 30-year fixed.

Active Management: June 2004 to June 2006
Then the Fed began hiking short-term rates in June 2004, LIBOR began rising, and it was time for LIBOR loan holders to shift strategies. In an uncertain rising rate environment, longer-term loans seemed like the right choice, but which one? The Fed’s consistent hikes on short term rates eventually flattened out the yield curve – meaning that spreads between intermediate and long term loan rates were very thin for much of the June 2004 to March 2006 period.

There was only about .125% difference between a 5-year and a 10-year ARM, and a .125% to .25% difference between a 10-year ARM and a 30-year fixed. Sure, there was some savings between the choices, but nothing so staggering as to suggest the obvious choice for active mortgage managers. So the choice came down to selecting a loan term that best fit their time horizon and monthly cash flow requirements. Many split the difference and chose the 10-year ARM – a long-term loan, but with a slightly lower rate than the 30-year fixed and more flexible payment options.

Active Management: June 2006 and Beyond
Now we are toward the end of the Fed’s tightening cycle. The yield curve is still pretty flat, but rates are higher across the curve. So what now for active mortgage managers?

For those who want the security of a fixed mortgage but can’t afford the payments in this rate environment, you can now get 30-year interest-only loans or 40-year amortization loans. Compared to a straight 30-year loan of $500,000, the 30-year interest-only would save you $430 per month and the 40-year loan would save you $225 per month. For those that want more monthly flexibility, you can get an Option ARM that would allow you to pay as little as $1324 per month or as much as you want on that same $500,000 loan. But you need to understand that an Option ARM (like every loan) is dependent upon your time horizon, and not always the right choice for long time horizons.

Actively managing your mortgage is all about clarifying your objectives and understanding the market. Your objectives help you set budgets and time horizons, and a properly qualified mortgage planner helps you select programs to fit your budget and time horizon. So while markets and loan programs evolve and change, the right planning can help you beat the market with active management, and help you use your home as part of a broader financial strategy.

 

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