This paper is an introduction to Fixed and Fixed Equity Indexed Annuity Contracts. It is not prepared as a product endorsement of any one contract or insurance company. When considering annuities it is important to understand the details of the contract being offered. Part of every investment consideration is how the particular investment fits into your overall plan. This paper will outline some of the basic features of funding fixed and fixed indexed annuities but for a full understanding you will need to meet with an advisor. Once the advisor understands your unique financial circumstances a specific recommendation can then be made.
Some Questions to consider What is most important to you when you look at your retirement accounts?
Is it Growth?
Life time income?
Guaranteed principal protection?
Tax Deferred or Tax Free appreciation ?
Believe it or not there are investments that offer all of these and more.
These investments are: fixed and fixed equity indexed annuities. An annuity is simply, a savings account with an insurance company. An annuity can be funded with either qualified money (pretax dollars) or non qualified money (after tax dollars). When considering an annuity one needs to understand the various components that make up this saving vehicle.
Guaranteed Surrender Account Value
Think of an annuity as if you were putting your money into two or three buckets. Each bucket is filled with the same dollars, but each treated differently by the insurance company.
The first bucket is: the Guaranteed Surrender Value Account (GSV).
This account is guaranteed by the insurance company at a fixed interest rate. Basically no matter how the other buckets perform, this account at the contracts’ inception has guaranteed value each year for the length of the contract.
Current Account Value
The second bucket is: the current account value (CV).
This bucket can either have a fixed interest rate for a predetermined period of time, example: five years.
It might also have an index crediting method to a cap. The caps are adjusted annually by the insurance company depending on market conditions.
I like to keep the index crediting method simple. One simple method is an annual point to point credit based on one of the market indexes like the S&P 500, Dow Jones Industrial Average or a Bond index.
When this method is employed the money in the bucket is tied to a market index and not invested directly in the market.
There are many types of index crediting methods. Your time horizon and sophistication will determine your comfort level with each method. Typically your advisor will choose the best method based on the current market. Each year you may change the method of crediting on your contract. So it is important to have an annual review with your advisor prior to changing strategies.
Surrender Charges
All annuities have a surrender charge as a percentage of current account value (CV) that declines each year depending on the length of the contract.
Surrender charges are actually a positive aspect to annuity contracts. The surrender charge allows the insurance company to make long term investments and prevents contract holders from making a “run on the bank” that would put other contract holders at risk. Typically the surrender charge is in force for the entire term of the contract allowing you to walk away without penalty or roll the contract into another annuity at the end of the term.
Life Time Income Riders
This is an optional third bucket where your initial funds are can be used to calculate a guaranteed life time income benefit (LTIB).
This account is completely separate from your Current Value Account and is only used to potentially calculate a life time income benefit.
All annuities can be annuitized and guarantee income for life. The LTIB rider is different from annuitization because it is not a return of principal and interest but based on a guaranteed value at inception.
You can choose a rider to be added to your contract, typically there is a nominal cost for the rider and in some cases no cost at all. Every contract is different but the riders all work in the same manner.
Bonuses
Depending on the term of the contract the insurance company might offer a bonus on money invested into the contract. Today these bonuses range from 5% to 10% with some bonuses paid later as a loyalty reward.
If the bonus is paid day one then $100,000 would create a CV account of $110,000 day one; also if you have the LTIB rider that account would also receive the bonus. Both the CV and the LTIB account will receive future interest credits based on $110,000. This is very popular because of the recent losses experienced in the market.
Conclusion
This is an introduction to some of the factors to consider within annuity contracts and is not meant to be an exhaustive explanation. If you are considering placing some of your money into an annuity contract you should fully understand the guarantees of the contract and the riders you are purchasing. Annuities are a great way to get tax deferred growth on your money; avoid probate while enjoying contractual guarantees. Many annuities also have other benefits: Nursing home / terminal illness waivers of surrender charges as well as no surrender charge on the death of the contract holder. Most modern annuity contracts are highly liquid as well. In most cases 10% may be withdrawn each year without surrender charges.
There are penalties from the IRS if one makes a withdrawal prior to age 59 ½ of 10% plus ordinary income tax on any earnings. The financial professional who offers this product must ensure it is suitable for your circumstances.
I am available to review all this information in detail and am looking forward to hearing from you.
When I hold a work shop one of the first questions I ask the group is: Where do you believe future income taxes will be by a raise of hands?
1. Lower
2. Same
3. Higher
In every case guess when all the hands shoot up into the air? That’s right; each time I ask 100% of the group think future tax rates will be higher. Why?
There are a lot of reasons to think future income taxes rate will be higher:
USA Today calculated in May of 2007 that American tax payers are on the hook for 59.1 Trillion dollars* in liabilities – this is before the recent financial meltdown and bailout package
There are 78 Million Baby Boomers retiring in the coming years
New government spending plans
Some experts believe the current highest marginal tax bracket of 35% might go as high as 60% in the near future. What does this mean to the population that has recently retired or will be retiring in the next 5 to 20 years? That the after tax value of your retirement income is in jeopardy of being significantly eroded by higher taxes.
How can you prepare your nest egg from this impending decline in spending power? One solution is to move as much of your tax deferred retirement accounts into tax free accounts as soon as possible.
There currently exists a three year window of opportunity to transform your deferred retirement (401(k)/ IRA) accounts into tax free accounts. This window closes by the end of 2010 under current tax law!
It is very important to act immediately and ascertain if you are in a position to take advantage of this opportunity. Call us today to learn more and schedule an appointment to begin the process of protecting your future income.
Excerpt from USA Today Article pre-market melt down
*”…Bottom line: Taxpayers are now on the hook for a record $59.1 trillion in liabilities, a 2.3% increase from 2006. That amount is equal to $516,348 for every U.S. household. By comparison, U.S. households owe an average of $112,043 for mortgages, car loans, credit cards and all other debt combined. Unfunded promises made for Medicare, Social Security and federal retirement programs account for 85% of taxpayer liabilities. State and local government retirement plans account for much of the rest. This hidden debt is the amount taxpayers would have to pay immediately to cover government's financial obligations. Like a mortgage, it will cost more to repay the debt over time. Every U.S. household would have to pay about $31,000 a year to do so in 75 years….” 5/29/2007 -- By Dennis Cauchon, USA TODAY
Facing the challenges that our current market conditions pose can be overwhelming. Many of us in our 40’s, 50’s and 60’s are very worried about our retirement accounts devaluation in recent weeks. There is a lot of fear in the market as well as uncertainty surrounding the government involvement in our major financial institutions. The buy and hold strategy that has been the hallmark of the mutual fund industry seems to have failed. Many of our retirement accounts are invested in mutual funds and we have experienced more than a 30% drop in value of these accounts. Will the general stock market recover? Yes - the only uncertainty is when. The Dow Jones Industrial Index took 25 years to recover after the crash of 1929 and it took only 2 years after the 1987 crash. The most recent down turn in early 2000 we had high volatility after September 11, 2001 until a low in 2002. Some histories to consider for both the DOW and S&P 500 indexes are at the end of this paper.
Given the stock market history there is a high likelihood that it will recover eventually but the time frame is always unknown. Many of today’s boomers have not saved enough for retirement and any down turn creates a high level of fear because the clock is ticking and no one is getting any younger. So what can be done right now to protect and grow assets for future retirement? First, there are two concepts that need to be discussed. What is the difference between short term and long term money and the best and worse places to park these funds? Short term money is liquid funds you need for emergencies such as short term unemployment and life’s unexpected occurrences. Short term money is liquid. Short term money should be parked in a safe guaranteed place. Safe guaranteed places can be FDIC insured bank accounts such as laddered Certificate of Deposits (CDs) and Deposit Bank Money Market accounts. Long term money is funds that won’t be used for at least ten years. This money should be parked in long term investment accounts. It is a mistake to park long term money in CDs or Money Markets for two reasons: low rate of return and interest is taxed as earned. Unless you are very near to retirement and will be drawing on this money in the next five years one should not keep long term money in these accounts. If you are worried about investing directly in the stock and bond market, in investments like mutual funds, here are some solutions. I have strategies that have a very high likelihood of success and are easy to implement for one’s long term safe retirement money.
Annual Lock in Reset Concept
What if I told you that you could open a ROTH IRA or ROTH 401(k) and this account had no limit on funds that could be invested AND there are no income limits that disqualify you from opening this account? In addition what if you had a roll over 401(k) or self-directed IRA in which you could not lose your principal but had some upside market return potential. Welcome to the new world of annual lock in reset concept. There are investments that act just like either a ROTH or Traditional IRA that have principal guarantees and market returns without the downside of market loss. Here is how the concept works. A lot of financial advisors recently have given up trying to select the best mutual fund to recommend to their clients. Most stock based mutual funds are judged against the performance of the S&P 500 index. Each year many mutual funds advisors earn bonuses based on how well their fund performed when compared to the S&P 500. 30% of the mutual funds do better than the S&P 500 each year with only one problem - the mutual funds that make up this 30% are not consistent each year. It is hard to pick the funds that will be in the 30% because you will be wrong 70% of the time. The other problem with mutual funds is that the manager is paid a percentage of the return on the funds and this can be expensive. Many financial advisors have concluded, eliminate the manager and invest directly in an index based mutual fund. Since the industry is based on the S&P 500 why not just buy a mutual fund that mirrors this index without the high expense of an active manager. The annual lock in reset concept takes this one step further.
Instead of investing directly in the S&P 500 index just buy a Call Option to get a piece of the index return if it is positive without incurring the down side risk if the index loses value. The yield on the money invested is the only portion that is at risk not the principal. An example of how this works would be buying an option on a piece of real estate. Assume you have $50,000 in the bank that you are saving to purchase a home. You have earned $2,000 in interest on this money. You find a home that you are interested in but you are uncertain about buying in the current market. You offer $2,000 for the option to buy the property in 12 months for $250,000. The seller accepts your offer because he really needs the $2,000 now. In 12 months you determine if you want to exercise the option to buy. The seller keeps the $2,000 regardless if you buy the property. If the market has appreciated you buy the house. If the market has decreased you let your option expire. All you have risked is the yield on your money not the principal. This is how annual lock in reset works as well. I have included a slide from a seminar presentation I give that shows how annual lock in reset works when compared to directly investing in the S&P 500 index. This is a snap shot of hypothetical 3 year period of time. The first year the S&P 500 gains by 10% therefore the $100,000 investment is now $110,000. If you are invested in an annual lock in reset, then this gain locks in and becomes principal. This is not the case if you are in an indexed mutual fund. The second year the S&P 500 loses 10%. If the annual lock in reset investment has a minimum credit of 1%, then you get the 1%. But if you are directly invested in the index, then your entire account will lose the 10% and in this case have only a principal balance of $99,000. In the third year if the S&P 500 gains 5%. The annual lock in reset account is credit the 5% and again this gain locks in as principal. As you can see that over this three year period the lock in reset account has a spread of 13% over directly investing in the index.
While the annual lock in reset concept is probably the best safe investment one can have for long term money there are some caveats. If one invests directly in the market their investment will raise and fall with the market. For example, in a year where the market experiences a 25% gain their investment will be credited with this entire gain. In these years the annual lock in reset concept will have a much lower return because the market gain will always be capped anywhere between 6.5% to 15% depending on the investment. Conversely if the market experiences a 25% loss the money invested directly in the index all the money is at risk for this loss. In the annual lock in reset only the yield on the money is at risk never the principal so in a market decline either 1% or 0% is credited to the account. Over time the annual lock in reset is a safe place to keep some of your long term money and it should yield respectable returns with very limited risk. In addition these investments if funded properly can either be entirely tax free in your retirement years like a ROTH or tax deferred like a tradition IRA. Lastly many of the traditional IRA like accounts offer up to a 10% bonus on money invested – this might help make up for some of the losses already experienced in the current market.
DOW JONES INDUSTRIAL AVERAGE RECENT HISTORY
• August of 1987 highest close 2722.42 and October of 1987 lowest close 1738.74 -36.13%
The DOW fully recovered these losses by October 1989 close of 2791.41
• January of 2000 highest close 11722.98 and October 2002 lowest close 7286.27 -37.85%
The DOW fully recovered by December 2006 with a highest close of 12510.57
• October of 2007 highest close 14164.53 to Present October 16, 2008 close 8786 -37.97%
When the DOW will fully recover and move past this recent high is unknown.
STANDADRD AND POOR 500 INDEX
• September of 1987 highest close 321.83 and October of 1987 lowest close 347.08 -23.23%
The S&P fully recovered these losses by October 1989 close of 353.40
• March of 2000 highest close 1498.58 and September of 2002 lowest close 815.28 -45.60%
The S&P fully recovered these losses by late 2007 close of 1526.75
• September of 2007 highest close 1526.75 to the present October 16, 2008 close of 929.13
-39.14%
When will the S&P fully recover and pass this recent high is unknown
An Explanation of the Operation of a Legal Reserve Life Insurance Company, underwriters of Annuities.
Through devastating world wars, financial recessions and depressions, sweeping epidemics, earthquakes and fires, inflation and deflation, the life insurance industry has protected people to a degree unmatched by any type of financial institution in the history of the world. Today the life insurance industry provides more than a trillion dollars of death protection to American consumers.
The financial reliability of the life insurance industry, even in times of financial panic, was demonstrated convincingly during the Great Depression of 1929-38 when some 9,000 banks suspended operations while 99% of all life insurance in force continued unaffected. Reinsurance, acquisitions, and mergers protected virtually all policyowners in the affected companies against personal loss.
Unlike most industries where size is a major measure of financial stability, life insurance's unique series of safeguards can make even the smallest company a tower of strength. In 1949 Mr. Leroy A. Lincoln, then president of the world's biggest life insurance company, Metropolitan Life of New York, stated: "You're as safe, as well protected and the cost is just as cheap if you buy from a small insurance company as from the largest."
The State Insurance Department
The State Insurance Department is a most vital department in each of our fifty states. Acting on its own state's insurance laws and regulations, it supervises all aspects of an insurance company's operation within that state. In addition, the State Insurance Department licenses all companies and agents to sell insurance within its boundaries. It must also approve all policy forms and in some cases, sales materials before they can be offered to the public. The Departments review complaints from consumers and mergers of companies which do business within its boundaries.
Required Reserves Ensure Payment of Policyholder Benefits
A large percentage of each premium dollar calculated by actuaries for each company goes into the policyowner's reserve fund. This policy reserve (Legal Reserve) fund is a liability to the life insurance company. The fund is established as a way of determining or measuring the assets the company must maintain in order to be able to meet its future commitments under the policies it has issued.
The reserve liabilities are established as financial safeguards to ensure the company will have sufficient assets to pay its claims and other commitments when they fall due. These assets are kept intact for payment of living and death benefits to the insureds. Life companies that comply with the legal reserve requirements established by the state insurance laws are known as legal reserve life insurance companies.
Periodic Company Examinations
Every year all legal reserve life insurance companies submit annual statements to the insurance departments of each state in which they are licensed to do business. The format and contents of the forms used are prescribed by the State Insurance Commissioners and they are a detailed report of an insurance company's financial status that is important in evaluating the company's solvency and compliance with the insurance laws. Every few years, depending on a company's home state law, all companies operating in more than one state undergo a detailed home office zone examination of its financial position. This audit is conducted by a team of State Insurance Department Examiners representing the various zones in which the company is licensed to do business. Companies licensed in only one state are subject only to an annual home office examination by their State Insurance Department.
Additional Security Safeguards
Reinsurance: Nearly every legal reserve life insurance company further protects its policyholders by reinsuring part of the coverage with a life reinsurance company. This is done when the company will not or cannot undertake a risk alone. Reinsurance prevents relatively sizable claims from depleting a company's policy holder reserves. The amount reinsured depends on many factors such as the size of the individual claim and the number of claims a company can expect.
Surplus: The surplus is the amount by which a company's assets exceed its liabilites. The surplus protects the policyholders and third parties against any deficiency in the insurer's provisions for meeting its obligations. The determination of the optimum amount of surplus that a company will retain must be based on experience, current conditions, and an awareness of the primary goal of maintaining a strong company that is always able to pay claims as they arise.
Mergers
In the unlikely event that a company's annual statement or its own examination reveals possible financial weakness, one of several avenues is open to the company: (1) Produce additional operating capital; (2) Sell its business to another life company; (3) Merger into another financially stable life company. A legal reserve life insurance company simply does not close its doors and go out of business declaring that all policies are null and void. Legal reserve life policyholders enjoy personal security safeguards unknown by other types of business.
Yours for Life Another unique advantage of legal reserve life insurance is that if one company is purchased or merged into another, there is no change whatsoever in the policy benefits or premiums. Legal reserve life insurance companies have established a public responsibility to respect both the letter and the spirit of laws and regulation so the interest of their policyholders are always protected.
Policyholders Protection Comes First
Today, as has been the case for many years, it is unlikely for the policyowner of legal reserve life insurance companies to lose their policy benefits. Through strict state insurance department regulations, the establishment of many state insurance guaranty associations and because of the insurance industry's history of financial stability and public responsibility to operate in a manner not detrimental to the welfare of the community, your policy is secured by industry safeguards.
In this YOUTube video is a funny populist take on our current economic meltdown by two British comedians. While this is humorous, it does demonstrate a fundamental lack of understanding of what caused our markets not to work.
There are four key components to this melt down:
(1) Crony-Capitalism (2) The Federal Reserve Itself (3) Mark to Market Accounting Rules (4) The Sarbanes-Oxley Law
While these four components are not exhaustive of all the causes these are the major actors of our current situation. I intend this article to be the beginning of a discussion on alternative ways to solve our current crisis as well as explain some of its root causes. I have included the video because it does demonstrate what most American’s believe to be the cause; fat cat greed, incompetence and bad lending decisions. I know that some readers will dismiss some of the arguments in this article and all I can ask is to continue educating yourself on rational economic principles. Never stop thinking for yourself and don’t believe the headlines that are meant to sell newspapers and news broadcasts.
Let us consider where we are today and the nationalization of our financial institutions. I will argue that neither a bailout or rescue plan that will put the American tax payer on the hook for mortgage loans is a good idea. I argue instead the current mess is the direct effect of our Federal Reserve System along with good intentioned laws e.g. Sarbanes-Oxley and Mark to Market accounting rules.
Crony Capitalism
The first key is something called crony-capitalism. Crony-capitalism is when market participants give lip service in defending free market capitalism while at the same time making deals with government officials to regulate and limit their competition. There is no doubt business owners are not necessarily defenders of free competition but their bottom line. If you follow the money into Washington it is easy to see why certain decisions get made and certain regulations are passed. This is not partisan this happens with Politician’s on both sides of the aisle. These cronies pretend to be for capitalism and free markets but will ask for the government to subsidize their decisions when they fail as well as regulation to limit competition. In August of 2007 when the private (not government backed– non Fannie Mae / Freddie Mac ) mortgage loans that were packaged and securitized began to no longer be purchased by wall street; there was an immediate sentiment: if it’s not backed by the Federal Government, then how can one know what these securities are worth? As the comedians in the video dramatized it seemed to have been a game of musical chairs with the last person holding a pool of mortgage money was left wondering if maybe too much money was paid for these security packages. What the video fails to explain is that in these mortgage packages all the mortgages are not equal. All the mortgages were not made to unemployed first time home buyers unable to make their payments. Not all mortgages even ones that adjust necessarily only adjust higher. The fact is that over ninety years the line between the government sector and the private sector in mortgage money lending has become very blurred.
The Federal Reserve
The Federal Reserve is the first culprit that is the foundation of this mess. It is neither politically feasible nor popular to criticize this federal institution when the general population has very little understanding of its role and the destructive nature of its decisions. With the nationalization of our money in 1913, this was the first nationalization project of the federal government. In 2013 the FED will celebrate its 100th birthday. What needs to be discussed and understood is it will also have eroded more of the average Americans wealth than any other government taxing system ever created. This institution can create dollars out of thin air that in turn devalues all the current dollars in the system, otherwise known as inflation – higher overall prices. Increasing the money supply typically drives interest rates lower. That is why there is a direct correlation between the FED decreasing the money supply to lower inflation and interest rates being pushed higher – remember the 80’s and Paul Volker. So what has the FED been doing? Increasing the money supply via federal debt and printing money that has created our inflationary pressures. Where do you think the additional money will come from in this “rescue package”? In my opinion, what the Fed and congress are doing is the largest power grab in the history of the federal government while it allows some private firms to buy assets at fire sale prices. Instead of changing the rules so the free market can correct its mistakes and return to sanity it will just make the government bigger. Do you really think that 95% of the performing mortgage securities have no value? There has to be a reason for this seizure and it is not the market participants “the fat cat Wall Street types”. It is the rules that are in place today that have caused this mess and it lies at our federal government’s feet because they make the rules.
Market Sentiment and Mark to Market While you watch this video these two comedians do a wonderful job in the beginning of why “market sentiment” comes into play. One major reason is a mark to market. Read this article if you are interested in a fuller discussion of this concept from William Isaac, chairman of the Federal Deposit Insurance Corp. from 1981-1985 that lived through the 1980’s S&L crisis. http://online.wsj.com/article/SB122178603685354943.html?mod=article-outset-box
Yes there is euphoria if you are marking to market in an increasing market or panic if you are marking to market in a declining market. This is what just happened. Why? What if you got an appraisal on your home and the value was determined to be $500,000 last year. Assume you paid $250,000 just five years earlier you feel much richer. What If you get an appraisal today and the home is worth $200,000, then you feel like you took a huge loss. Let say the reason your home was valued at $200,000 is because your neighbor was foreclosed on and the bank sold it at auction. Is your home worth $200,000 really?
What mark to market impels you to do is, complete an appraisal on your home daily, regardless of how long you plan to keep this home. If you did not sell at $500,000 there was no gain and if you don’t sell at $200,000 there is no loss. Just because your neighbor is financially distressed and was foreclosed on and his home sold for $200,000 doesn’t mean you will take the same loss. But under the mark to market rules along with the liability of the Sarbanes-Oxley law; institutions that hold mortgage securities have to mark the price (valuation on the books) of like securities to those of institutions that are distressed and selling at foreclosure sale prices. Further since the market was never allowed to filter out the truly failing mortgage from those that are performing – partly because of how they are packaged and sold – the market has not been able to price the good mortgages and discount the bad. In the simplest terms this can be understood: There were lending products created over the last ten years that had a high likelihood of not performing – bad loans. There were also loan products however non-traditional that have a high likelihood of performing – good loans. The bottom line problem was the market was never allowed to empirically discover the good from the bad.
The Sarbanes-Oxley Law The Sarbanes-Oxley Act of 2002 (often shortened to SOX) is legislation enacted in response to the high-profile Enron and WorldCom financial scandals to protect shareholders and the general public from accounting errors and fraudulent practices in the enterprise. The act is administered by the Securities and Exchange Commission (SEC), which sets deadlines for compliance and publishes rules on requirements. It also imposes criminal penalties on the officers of a corporation signing off its balance sheet. The SOX law along with the Mark to Market requirements has caused a great deal of the devaluation of the financial institutions.
Conclusion
I think between Mark to Market along with crony-capitalism these loans have not been properly valued. Crony-capitalism prevented the market participants doing the hard work of figuring out what loans were poorly made; it was easier to go to their favorite Uncle Sam for protection. This is what I think began, in the summer of 2007, the mantra: “I am not buying it unless it is guaranteed by the government.” Now the investors are pleading to have the Government to buy these loans now so that they can buy them back at a profit later. Let’s think before we react again and again only to make matters worse for our future. Do you really want to eventually only have large government controlled banks backed by your tax dollars? Do you really want to replace all the private lending institutions with members of congress? Don’t you think it is better to have individuals making daily decisions in their best interest as opposed to a committee making decisions in their best interest – that interest being keeping their job on the committee? If we give this much power to such a small group of people, whom will they ultimately serve? The last question is how can this small group know better? What possibly can guide them in making correct decision? These are my questions I look forward to your answers and further comments. Further Discussion of the How the Market Works
What is the secondary market that buys non-government backed mortgage debt? The Collateralized Mortgage Obligations (CMO) with their corresponding Credit Default Swaps (CDS) are pools of mortgage loans made to various credit types from A paper to D paper. Each pool is weighted with these credit classes to defend against the risk of any one credit class defaulting. The uncertainty of their overall value is based on how these mortgage loans were packaged. What appears to have happened was when the market began to shift and began to appear that loans were defaulting; the buyers of these pools could not distinguish what classes had the possibility of defaulting. The entire pool was unable to be valued because there was no way to separate A paper from D paper. How did they ultimately become worthless is the real question?
Deposit Banks vs. Mortgage Banks
One first needs to understand the difference between lending money to sell into the secondary market the use of credit lines or hold in portfolio the use of depositor’s money. This is what fundamentally separates the pure mortgage banker from a pure deposit bank. A mortgage banker has short term lines of credit from large institutions that are used to make individual mortgage loans that are either sold one at a time or in a pool. The buyers of the loans eventually are sold to institutional investors (Wall Street) in very large pools -- for this discussion I do not include Fannie Mae or Freddie Mac. Mortgage bankers vary in size from small operations to large national operations. The large and mid-size mortgage bankers were the first of the mortgage lenders to become bankrupt beginning in August of 2007. The larger mortgage bankers had actually created new loan products that were packaged and sold into these pools. These loans were comprised mostly of subprime, Alt A loans and jumbo loans. For the most part these loans were adjustable rate mortgages because of the inverted yield curve at the time. One could classify all loans not backed by the government (conventional – Fannie / Freddie and Ginnie – FHA / VA) into this group. Mortgage bankers had been making these loans since the mid 1990’s. The market had become increasingly competitive over the past ten years with the explosion of these products. Therefore more and more loan programs were created to compete with older loan programs. All the major lenders jumped into this market, including large institutional banks creating divisions for mortgage banking purposes trying to carve out new niches to be profitable. For this discussion I am ignoring Fannie and Freddie and their foray into the Alt A and Sub-prime market because it is an entire article in itself. The deposit banker has the ability to make loans from its deposit base within guidelines defined by banking regulations typically holding 10% of the deposit and lending the remaining 90%. These deposit banks therefore can make portfolio loans up to a defined percentage of deposits at which point it will theoretically run out of money to lend without further deposits. Therefore most deposit banks also sell mortgage loans on the secondary market. Today the only A paper competitive jumbo loans on the market are made by deposit banking institutions for their portfolio. In a future article I am going to expand on why I think Washington Mutual failed but the main reason was it moved away from a portfolio lending philosophy to one that mirrored the giant lender Countrywide.
Secondary Market Stopped Working
Why were the mortgage bankers the first lenders to fail? The main reason for mortgage bankers going bankrupt, take for example American Home Mortgage a national mortgage banker the first major to go under, they had new mortgage pools to sell into the market and found their market closed. The inability to sell their mortgage loans, quickly led to their credit lines being closed because they could not meet margin calls. Why? The institutional banks that gave the originating lender a credit line wanted payments on these lines and when the lenders ran out of money because they could not sell these pools; were forced to sell all their loans at deeply discounted values – a fire sale. These fire sales tie back to the pools that already existed in the market. The owners of these pools were quickly questioned on the value of all the underlying mortgages via accounting standards. The first problem was the accounting rules that institutions had to mark these securities to market which I discuss further in the article. These existing pools now had to be marked to the fire sale market. This is what seized up the market in the first place. In essence all mortgages could not be valued properly and had to be valued at the deeply discounted value of the insolvent mortgage bankers. This created an increasingly negative spiral downward for the mortgage pools. At first I thought what was happening in late 2007, was the large institutions were eliminating their competition by increasing margin calls regardless of the class of mortgage assets being sold. I sat and could not believe that all non-government mortgages all of a sudden had no value. An example is Thornberg Mortgage. Thornberg was a recognized well operated mortgage banker that made loans to highly qualified borrowers with non-traditional jumbo loans. Thornberg is still in business today but has no competitive mortgage loan product to sell. But the questions from firms like Thornberg asked; how can Wall Street paint all mortgage loans with one brush? Thornberg’s argument was there is a real difference between our paper and sub-prime paper and the two are not equivalent. The questions and arguments went unanswered. But maybe Thornberg should have questioned the accounting methods imposed on Wall Street as well as whom the market believed the Government, the Fed, would ultimately back? Over the past few months we all have seen exactly which firms have been backed.
Is it possible to get great Jumbo loan rates in today’s market? The answer - absolutely! The strategies I use in this market place, onhow to best negotiate and buy property*, give the Jumbo borrower some very positive opportunities.
The current definition of a Jumbo loan is an amount borrowed larger than $417,000. However if the loan amount is between $417,100 and $523,750 (many counties in eastern MA -- your counties maximum loan limit maybe higher or lower), then this is considered a Conforming Jumbo until January 1, 2009. The Housing and Economic Recovery Act of 2008 that was signed into law will increase the conforming limit ($417,000) to 115% of an area’s median sales price. I expect that for most counties inside the RT 128 belt of Massachusetts the definition of Jumbo loans will be those loans greater than $481,850 beginning in the New Year.
Most Jumbo loans are not on the edge to the conforming market, a few thousand dollars over the limit. Many families find they need or want a mortgage much greater than the current limit. Typically a Jumbo borrower is able to put twenty percent or more down on the purchase, typically from the sale of their current residence. If this describes your circumstance read on.
So what are the best Jumbo loan products available and why? The fact is the thirty-year fixed rate market has become very expensive for Jumbo financing, especially for a loan amount over $650,000. Therefore I have found that the intermediate portfolio adjustable rate mortgage (ARM) loans work best. These are the five and seven year fixed loans that adjust after the initial fixed period. My first reason to use these products is because the spread in rates between the 30-year fixed rate and the 5/1 or 7/1 ARM have widen sharply. The second reason is that private (non-governmental) 30- year fixed money has all but evaporated from our market; this leaves only the portfolio lenders. The third reason I recommend these loans is the current housing market slump will not last forever. As the housing market recovers there will be ample fixed rate mortgage money to replace this loan if needed; see the chart on the next page from the Office of Federal Housing Enterprise Oversight. This is a national chart created by the forecasters’ that the entire real estate industry trusts, because they predicted the downturn and saw the bubble in 2005 and 2006 – this is the organization that got it right! You will be hard pressed to pick the absolute bottom of this market. By the time the bottom is recognized the recovery will already be six months to twelve months into its cycle.
Other considerations for using portfolio intermediate fixed ARM is the Yield Curve. I would much rather stay on the short term end of the interest rate market than the long term. The traditional yield curve is plotted on an X and Y chart where X equal interest rate and Y equals term. Historically one should find that as the term of the debt repayment lengthens the corresponding rate is higher. So a one-year term Note would have a lower interest rate than a thirty- year term Note. However one indication that a recession is forthcoming is when the Yield Curve will become inverted; in this case short term interest rates are actually higher than long term interest rates. This has happened several times in the last two decades; I blame most of it on the Federal Reserve policies and unfortunately those cannot be expounded in the scope of this paper.
Bottom line best overall cost of financing today’s Jumbo loan is with the use of 5/1 or 7/1 ARM. The housing market will recover. Sanity will eventually return to the mortgage marketplace where entrepreneurial lenders will develop and be able to sell Jumbo fixed rate loans as competitively priced as the conforming market. Don’t let the irrational fear of an ARM trick you out of purchasing in this housing market. You will lose more by not acting.
*I have strategies on how best to negotiate and buy property in this market. I am building teams of realtors and other professionals to implement and utilize these strategies so that both the buyer and sell win in every transaction. Call or email me today to learn more on how you can implement these strategies to win in this market.
I have been receiving a of lot calls from past clients inquiring whether or not if now is the time to refinance. Many inquires concern an adjustable rate mortgage that has been fixed for the past five years and now is set to adjust. There is a misconception that all adjustable rate mortgages (ARMs) adjust to a much higher interest rate. This is not necessarily the case. There are many Intermediate fixed term ARMS that have very favorable terms at adjustment. The fact is all ARMs are not alike. The Press will headline Subprime ARMs that were given to borrowers a few years ago with credit, income and asset issues. These Subprime ARMs do contain new terms at adjustment that will insure the adjustment interest rate will be higher than the initial NOTE rate. The fact is not all ARMs are subprime there are Prime or “A” paper ARMs as well. There is a large spread between these two types of ARMs and if you have an ARM you need to understand what the terms of your loan are before making a decision to refinance.
Definition of an ARM
An ARM allows the lender the ability at a future date to adjust the interest rate and payment terms of a mortgage loan to the market based on two factors. The first factor is a published and market accepted interest rate Index; the index also has to be outside the control of the lien holder. The mortgage industry has accepted several Indexes to tie its various mortgage loan products. Here is a list of the most common residential mortgage indexes:
CMT –These indexes are the weekly or monthly average yields on U.S. Treasury securities adjusted to constant maturities.
MTA -- The Monthly Treasury Average, also known as 12-Month Moving Average Treasury index (MAT) is a relatively new ARM index. This index is the 12 month average the monthly average yields of U.S. Treasury securities adjusted to a constant maturity of one year. It is calculated by averaging the previous 12 monthly values of the 1-Year CMT.
LIBOR -- London Inter Bank Offering Rate is an average of the interest rate on dollar-denominated deposits, also known as Eurodollars, traded between banks in London. The Eurodollar market is a major component of the International financial market. LIBOR is quoted as a one month, six month, and one year index.
PRIME -- The Prime Rate is the interest rate charged by banks for short-term loans to their most creditworthy customers whose credit standing is so high that little risk to the lender is involved. This index is directly affected by the Federal Reserve interest rate policy. This index is widely used for Home Equity Lines of Credit and Second Mortgage loans.
The index will raise or fall depending on the general credit market and each month a snapshot of the index is taken and used by mortgage lenders to determine a given loan’s interest rate. All the above indexes are an indication of the short term interest rate environment – debt that is repaid within a one year time frame or shorter. There are longer term indexes but for our discussion most residential mortgage ARMs are based on one of the above Indexes.
The second factor to an ARM is the Margin. This is the fixed percentage that will be added to the Index at adjustment to determine the new interest rate. Margins vary widely between Subprime and “A” paper loans for example:
On a Subprime loan the margin might equal the start rate / initial interest of the Note taken at closing. If the interest rate was initially 7% for the first three years of the loan the margin might also equal 7%. Therefore the interest rate will always be at least 7%, but only if the corresponding index were to go to zero. That would mean a zero interest rate environment, not likely, so this borrower will be looking at an increase at adjustment. An “A” paper loan will typically carry a margin less than 3% and has no relation to the starting Note rate. Therefore at adjustment the “A” paper loan could very well adjust lower depending on the current interest rate environment. The two components to all ARMS are the index, this will change over time, and the Margin a fixed percentage added to the index to determine the new interest rate.
In addition to the two elementary components Index and Margin there are two other concepts that need to be understood by the borrower. These are the interest rate caps and adjustment term. Interest rate caps are contractual and defined in the mortgage Note at closing. These caps will contain or keep interest rates from adjusting above or below a defined level. For example the interest rate caps might be expressed as 5/2/5. This means that the interest rate cannot adjust more than 5% at the fist adjustment, no more than 2% at each subsequent adjustment and never adjust more than 5% over the loan’s lifetime. 5/2/5 are typical caps on “A” paper 5, 7 and 10 year fixed ARMs, but you might also see 2/2/6. How it works is if the index used for the mortgage raises enough so that the new interest is above 5% the initial start rate, then the lender will be able to adjust the new rate to that level. This way the lender is able to receive interest comparable to the current market interest rates. Further if the loan were to adjust the full 5% at the first adjustment it could never be higher than this amount for the life of loan. The second cap, in this case 2%, comes into play when index has increased or decreased less than the 5% during the initial fixed term. Therefore the loan would adjust to the new interest rate index plus margin for the new fixed period of time. At each subsequent adjustment the interest rate can only increase a maximum of 2% until and if it reaches the maximum of 5%. The period of time the loan’s interest rate is fixed once more at each subsequent adjustment is the adjustment term. This is generally based on the index chosen for the mortgage product. For example if the lender uses the CMT or 1-Year LIBOR index, then the loan will adjust annually after the initial fixed term of the Note. If a 6-month LIBOR is used, then the loan will adjust every six months. If the MTA is used, then the loan will adjust monthly for the remaining term of the loan and so on.
Examples:
An “A” paper mortgage ARM; initial interest rate 4.75% for the first five years, then adjusting each twelve month period thereafter for the balance of the twenty five year term; most ARMS are based on a 30 year Amortization. The Margin is 2.75% and the index used is the 1 year LIBOR with 5/2/5 caps. If this loan was closed in October of 2003 the October 1-Year LIBOR index was 1.5625%. I want to bring to your attention the fully index rate (Margin plus Index) at the initial closing. In 2003 the fully indexed rate was 4.375% rounded to the nearest eighth (1.5625% plus 2.75%). As you can see the initial Note rate was .375% higher than the index plus the margin. In October of 2008 this loan will adjust based on the terms of the Note. However the lien holder cannot wait till the October’s index is published to adjust the interest rate. Therefore the terms of Note will generally allow for 45 days prior to adjustment the then index will be used and a notice of the new interest rate will be sent to the borrower. In our case that would mean before August 15th 2008 the August 1-year LIBOR index will be used to by the lender. The 2008 August 1 Year LIBOR index is 3.244%. Therefore in this example the new interest rate will be 6.00% rounded to the nearest eighth (3.244% plus 2.75%) and a letter explaining this change would be mailed to the borrower. That is a 1.25% increase and is much lower than current fixed ate interest rates that stand around 6.75%.
Let’s use the same example but change two of the components. Lowering the margin to 2.25% and switching the Index to the 1 Year CMT. The October CMT was 1.25% plus our margin would have equaled the fully indexed rate of 3.50%. In this case the initial Note rate was 1.25% higher than the initial fully index rate. Fast forward five years the August CMT is 2.12% plus our margin will equal a new interest rate of 4.375% (2.12% plus 2.25%)—that would be a .375% decline in rate. In this example you can see the difference in which index is used as well as the margin. There can be a significant difference between ARMs depending on the initial structure.
One caveat, the CMT was used widely a few years ago but today most ARMs are based on the 1-Year LIBOR.
If we consider the caps in both cases the first adjustment cap would not come into play because the index did not raise enough for the adjustment to climb 5% above the initial start rate of 4.75%. The Note’ index with 2.75 Margin would have to climb to 7% and the Note’s index with the 2.25 Margin would have to have climbed to 7.5%. Historically over the past 18 years the CMT highest point was 7.78% in August 1990 and went to 7.14% in December of 1994. The 1 Year LIBOR has been .25% to 1% higher in any corresponding month than the CMT.
This doesn’t mean the CMT is superior to the 1 Year LIBOR it just means you need to understand the terms of your mortgage Note and how these affect the interest adjustment.
In my examples there are clear differences between Subprime and “A’ paper ARMs. The fact is Subprime ARMs might be considered toxic; this set of borrowers has been excluded from being able to refinance these ARMs because of the illiquidity of the current mortgage market. For many Subprime borrowers the only way to refinance is with an FHA insured mortgage or asking the current lien holder to restructure the terms of the mortgage note. However the “A” paper borrower should not confuse their situation with that of a Subprime borrower nor ignore the benefits of intermediate fixed ARMs. In fact if one is purchasing a home today and needs a Jumbo loan (a loan amount above $523,750 – jumbo conforming limit for most counties inside the 128 belt of Massachusetts), then your only choice may be a five or seven year fixed ARM. Many of the available Jumbo ARMs have favorable terms and should be considered as part of the mortgage planning process.
If you are considering refinancing, have your Note reviewed by a mortgage planning professional. This will help you understand where the loan might adjust so that you can make a comparison to the current interest rate environment; you might be pleasantly surprised. As part of my planning process for my clients we perform an annual review and an ongoing review with a mortgage under management process. To learn more on whether you should refinance contact me and I will perform a review of your current mortgage and make recommendations based on your future goals as well as interest rates.
This is the first question I get when someone learns what I do for a living. As a mortgage planning professional I cringe at this question. I have never liked the fact that my industry has conditioned the general borrowing public to ask this question when they inquire about a mortgage. To ask it in the current market, the unsuspecting applicant is asking for trouble.
Since the implosion of many mortgage lenders and the private sector shirking the mortgage market since last summer, there have been many very important changes to how a loan is quoted. The headlines are scary. There are fewer loan programs left and credit scoring rules the mortgage industry. The major mortgage funding markets that exist at the moment are FANNIE MAE, FREDDIE MAC and GANNIE MAE. Within this market lurk many caveats to be understood by the consumer prior to getting a solid interest rate quote. No longer is it possible to pick up the phone and get a reliable quote unless you are able to access the lenders guidelines for what are known as risk based pricing adjustments and loan level price adjustments.
The government backed mortgages currently have the lowest interest rates on 30 year fixed rate loans. If your loan amount is above the government current limits, then you must rely on the private sector to fund your loan. In that case the lowest cost loan products are intermediate Adjustable Rate Mortgages with initial fixed terms of 5 or 7 years. To qualify for these loans however you must have high FICO scores, a sizeable down payment or equity along with adequate income to qualify. For this article I am putting the true Jumbo loan aside and will focus on the Government market.
The fact is the majority of homes purchased and refinanced fall into the category of the government loan arena. Finding out what the payment is within this arena is tricky and really cannot be accomplished without having your lender having reviewed:
Credit report and scores
Income documentation
Asset documentation
Appraisal of the property
There is no way around the fact that all four of the above will determine the terms of your new loan – you cannot guess at these in today’s market.
Why? Because of risk based pricing adjustments and loan level price adjustments. These terms are the reality and are set in stone. To stave off losses both FANNIE and FREDDIE have created a systems that compensates for the greater risk. FHA currently has adopted a similar risk avoidance system that is a little softer than FANNIE and FREDDIE. I will explain the impact on an interest rate quote in the world of FANNIE over two scenarios later in the article. FHA is up in the air as to whether the risk based pricing will continue or not. The Housing and Economic Recovery Act was signed into law on August 1st, 2008 (That was Bill H.R.3221). It will become effective on October 1, 2008 and it eliminates risked based pricing on FHA loans. However on its heal Bill H. R. 6694 authorizes risk-based insurance premiums for FHA mortgages. This is a perfect example of constant change in the mortgage lending industry.
LOAN LIMITS:
FANNIE MAE / FREDDIE MAC – Make up the conforming mortgage loan market that define the single family (1 unit and Condo) loan limit as $417,000; except in Alaska, Hawaii, Guam and the U.S. Virgin Islands, which are 50 percent higher than the limits for the rest of the country
FANNIE MAE / FREDDIE MAC (Stimulus Package) –if the loan amount is above $417,000, then it is a Stimulus or so called “JUMBO conforming” (only through December 31, 2008) – the loan limit varies by county go to:
GANNIE MAE – Is the agency that insures FHA and VA loans with the full faith and of the Federal Government. FHA currently follows conforming loan limit guidelines including up to the stimulus package loan limits. The VA insurance program gives an eligible Veteran a certificate that is worth 25% of the loan amount up to $417,000 conforming limit on single family home. Therefore up to $417,000 loan amount no down payment is required. However a Veteran that qualifies can have a loan up to $1,000,000 putting a 25% down payment on the excess balance over the $417,000 of the purchase price – these are called Super Jumbo VA loans.
FANNIE Adjustments:
You are shopping around for a mortgage loan and look on the internet for current rates. You find there is a lot of variation between the lenders advertising. How can you get an accurate read on an interest rate? Let me tell you that you can’t - you need to find a professional you trust and apply for the loan. Here is why.
Example one:
$500,000 purchase price and you have 10% to put down that leaves you with a $450,000 loan amount request. This means you will have a Jumbo conforming loan with private mortgage insurance. Since it is conforming jumbo your rate is already affected higher than if the loan amount was $417,000 by about .25%. Now consider FICO score - you need a 700 to get a loan. If you don’t have this score you will need to put 20% down. This used to be accomplished with a second mortgage to make up the additional 10% needed. Good luck finding one in today’s market. So you find the second mortgage you will still have an additional .75 to 1.50 points added to the price which will increase your rate by a .25% to .375% over the Jumbo .25% already added. Another pitfall is if the property falls into a declining market county, then there may be an additional 5% down payment requirement.
Example two:
You want to refinance out of your adjustable rate loan into a fixed rate. You think your home’s fair value is $500,000 and you owe $400,000. Let’s assume 30 year fixed interest rates are advertised at 6.5%. Now you need to be aware that that rate assumes a minimum FICO score of 720; if your score falls below this level there can be anywhere between a .50 point to 2.50 point price adjustment. How this translates to rate is .50 point will equate to .125% higher rate, a 1.50 point adjustment will be .375% higher in rate and 2.5 point adjustment will be .625% in rate. So you could be looking at a 7.125% instead of the advertised 6.50%. We haven’t considered the appraisal - if that comes in lower than $500,000 you are going to need private mortgage insurance if available with your given credit score. Again watch out if you are in a declining market county another 5% cut in your loan. There are many examples of why it is impossible to get a rate quote over the phone. The two examples above is just a sample. If you are seeking a mortgage use a professional and give them all your information and apply for the loan. Let the professional handle the job of finding you the best possible loan for your current situation and heed their advice. If you are worried about making a mistake in choosing the mortgage professional here are some tips you can follow before you meet with anyone:
Get a copy of your credit report and learn about Credit Scores – there is an entire section of my web site dedicated to this topic at
Gather your documentation together – income documents (W-2 and Tax Returns last two years) know how much money you make in gross income
If you are refinancing look up your property online at http://zillow.com or some other valuation web portal – no this is not an appraisal but it will give you a quick indication of the value -- also check Assessment value of your home on your real estate tax bill or online – most of the time Zillow has this information updated.
If you are purchasing get a basic idea of the price of properties you are most interested in – go to some open houses and do some research. Target an area to learn how quickly properties are selling.
A good mortgage professional will have the tools to further educate you on mortgage options and also help you structure how to make an offer on the property with your real estate agent. In this market the sellers are very concerned about the sale falling through because of financing problems. Believe me if you are positioned with a realistic loan approval and understand how you want to structure your purchase agreement you will be in the best possible position to close on the home; but you need a team of professionals on your side to put this together – including a mortgage professional and real estate agent. If you need to refinance because of an adjustment in your current ARM, then get a realistic valuation of your home and get that credit report. You won’t be able to affect the value of your home but you could improve your credit score prior to applying for the refinance. Remember whether you are buying or refinancing the more you understand the current lending environment the better.
As we progress in 2008 there are two weaknesses that need to be addressed in our housing market by the real estate agent. Simply put there are too many homes for sale and fewer mortgage products. This reality can be addressed by strengthening each weakness at the same time.
First we need to fully understand both weaknesses. There are various types of sellers in today’s market adding to the inventory. While I cannot name every type of seller, I would argue there are three broad categories in any real estate market.
The “Have to ” seller: Foreclosures (bank owned) and the short sale
The “Need to” seller: Relocating or having a life event; divorce, death, long term illness, job loss, etc.
The “Want to” seller: Those that would like to sell their home for all the normal and numerous reasons
The more “Have to” sellers that exist in a given community, then the weaker the price points will be for competing properties. The fact of the matter is any neighborhood with bank owned or owners seeking a short sale will drive overall sales prices down. The “Need to” sellers must sell but have enough equity and cash flow to withstand a typical sales cycle. However this category of sellers must sell the property in most cases. In a stable market “Want to” seller is the market. In a stable market the “Have to” and the “Need to” would make up a small percentage of the sellers. However a fact confirmed in every bleak headline the “Have to” sellers are growing. The “Need to” sellers will only grow if your local overall economy weakens to the point of an exodus for better opportunities elsewhere. At this time it appears the “Need to” will remain in historical percentages to the occurrences of life events. Therefore the stable market “Want to” seller is in competition with the growing “Have to” and perhaps a higher percentage of “Need to” sellers. But this is not the only weakness.
The second market weakness is the buyer. Today’s buyer is weaker in direct relation to income and credit. The reason why the “Have to” sellers are growing so rapidly is the inability to finance. The mortgage programs that allowed these sellers the chance of homeownership have been eliminated. Regardless of your personal views on the mortgage lending debate as to whether these programs were right or wrong, the fact is these programs are now history and it has had a negative effect. The direct affect is the buyer not able to pay cash for the property must document his income. This might seem like common sense that a borrower must document income but how lenders verify income will limit the given pool of eligible buyers for a property. There are additional numerous mortgage weaknesses that are preventing buyers from purchasing property that I will expound on in future articles for example: credit score price adjustments, increasing interest rates and today’s adjustable rate mortgages. I will focus on the income needed weakness and how a seller can strengthen their listing and sell their property.
As discussed there is an overcrowding of properties on the market and the buyer pool has become more limited. As a realtor your focus is on the “Want to” sellers the stable market but your buyers are first drawn to the “Have to” seller’s listing. You and I know that this appeals to buyers because of the intrinsic below market price point that is hoped to be found by bidding on these properties. The first problem with the bank owned or short sale is the length of the contract. Many times a buyer offers a respectable price for a property only to wait three or four months for the deal to fall apart because the seller cannot accept the price offered. At best trying to put together a “Have to” sell deal is a crap shoot unless you can get some control over the process. If you show your buyer or try to attract the buyer to a “Want to” sell listing the obstacles from the buyer are:
Questions if it is the bottom of market?
Waits to see what will happen over the summer, this turns to fall and so on.
Needs to sell his home first to buy the dream home
Can’t qualify for the home by the lenders standards
Wants a deal
As the listing realtor on the “Want to” sell listing you are constantly asking your seller for a price reduction to get activity to the property. Is there a solution? The answer is yes.
As the realtor you need to confront both the seller’s weakness and buyer’s weakness simultaneously via a team approach to closing the sale. Who makes up this team is extremely important as is the education process of both the buyer and seller. For a successful transaction both the buyer and seller must win for the deal to move forward. You need to adopt a financing solution into the marketing of the property. The team is comprised of the listing agent, buyer’ agent and mortgage planner. The buyer’s agent must bring the buyer to a mortgage planner that understands both the lending environment as well as the buying process in our current market. As a mortgage planner I illustrate the difference between getting $30,000 off a sales price vs. using that same amount of money toward lowering the total cost of financing. The listing agent needs to understand how to position the property from a financing perspective to have it stand out from its competition. How do you think a property might be better positioned: “New price seller is highly motivated” or “Seller funded below market interest rate”? You can no longer ignore the mortgage and its affect on the transaction. How the mortgage is structured is an integral part of having success in this market. Understanding current lending guidelines and using the unique ability of the seller to affect mortgage terms is a huge benefit. The fact is if you can have a permanent effect on the buyers payment you will affect your pool of qualified buyers. I have adopted a program that can be immediately implemented into your sales process that will allow you to sell the “Want to” sell listing. It addresses both weaknesses in our market and succeeds when adopted. Contact me if you are interested in learning more about applying program. In addition I have an expired listing marketing approach as well. I service the entire Massachusetts, New Hampshire and North Carolina market.
Let's assume you were looking to buy a home last year and instead of purchasing the home in a traditional way you offered the seller an option to buy the home at a specific price a year later. For this option you pay him $3,000 from the interest earned on money you have earmarked for the down payment on this property. Now the seller may not like this offer but decides to accept the option because of the current lack of buyers. A year passes and you assess the real estate market and the current value of this home - now you are able to decide whether or not to exercise your option. If the market has improved by 10%, then you would buy the house at last year's price - with the 10% gain intact. If the market on the other hand lost value - maybe decreased by 20% -- then all you lost was the $3,000 you paid for the option. By using this option you have limited your risk and remained in control.
You can do the same thing with your long term savings accounts like retirement, college funding and other future needs. I have shown many clients the benefits of creating liquidity, safety and respectable rate of return on their retirement accounts by using their idle lazy home equity and other savings to propel the future retirement income. There is no reason why you can't use these safe albeit unconventional strategies to increase your control over your financial future. Stop driving to your financial destination using only your rearview mirror. Let me show you how to look through the windshield. Call me to schedule a presentation of these unique savings strategies and financial vehicles.
This is a slight take off from an ad in the 80's in that Wendy's asked "Where's The Beef?" Well the mortgage money resides with the three government institutions Fannie Mae, Freddie Mac and Ginnie Mae. If your mortgage loan falls outside of any one of these three institutions guidelines, then you will have a harder time finding your beef or new mortgage money. Without trying to give a history of these institutions lets suffice to say that because each of these is backed by the Federal Government taxing ability to some degree (Ginnie Mae the greatest) that investors that buy mortgages in the market are comfortable buying these agency's mortgage debt.
Here is the current mortgage landscape. Fannie Mae and Freddie Mac lending guidelines are virtually the same when compared to one another. These agencies are primarily known for lending on residential property consisting of one and up to four units. A number you need to understand is the maximum loan limit allowed to be lent on a single family residence, including condominiums, which stands at $417,000. This loan limit has been consistently raised each year until 2006 where it has remained at the $417,000 (the limit in Alaska, Hawaii, Guam, and the U.S. Virgin Islands is 50 percent higher than the limits for the rest of the country.) You can go to http://rs6.net/tn.jsp?t=5yzpyicab.0.0.uoqzytbab.0&ts=S0313&p=http%3A%2F%2Fwww.fanniemae.com%2Faboutfm%2Floanlimits.jhtml%3Fp%3DAbout%2BFannie%2BMae%26s%3DLoan%2BLimits&id=preview for a history on loan limits and the current limits for 2, 3 and 4 unit properties. What is little known is that both Fannie Mae and Freddie Mac offer a wide variety of lending products to the lending industry. For example: Interest only loans both fixed and adjustable, 100% financing loans to both highly qualified and as part of community lending initiatives with income restrictions but mortgage insurance subsidies. On the adjustable mortgage matrix you can borrower on a 3, 5, 7 and 10 year fixed term with either a LIBOR (London Interbank Offered Rate) or US Treasury as the underlying index. They also offer what the industry calls expanded criteria or "A" minus loans - a higher credit standard than sub-prime but with loosened guidelines compared to its "A" paper counterpart. These agencies have been offering these products for the past several years as the Alt A and Sub-prime industry grew. The only difference is the lenders offering those loans did not have the backing of the government or our tax dollars therefore those lenders have gone out of business when the market "re-priced the perceived risk" of these loan products.
Ginnie Mae has also been sanctioned to step up to the plate and lend with the full and complete guarantee of the Federal Government taxing ability. This agency is better known for providing FHA and VA loans. In January the congress passed legislation allowing FHA to increase its loan limits to those of Fannie and Freddie. FHA via the Department of Housing and Urban Development is the insurer of mortgage debt that is pooled into Ginnie Mae Securities. So instead of having private mortgage insurance companies (PMI) underwrite the risk of mortgages when loans are greater than 80 percent of the property's value, the government underwrites this risk called MIP (mortgage insurance premium). Today loans that the private mortgage market priced at rates of between 9 to 15% the government is pricing this risk at 5.5%. Once you have an FHA loan you never have to qualify to refinance it again as long as you make your payments, the new interest rate is lower and you don't take cash out. FHA has effectively replaced the entire sub-prime industry in the last six months. One way to learn if a loan product is popular and profitable for a lender; listen for increased radio and television ads promoting the product. FHA also insures the Reverse Mortgage loan product that has become popular recently with seniors.
Ok you say that is all well and good for those that have mortgages that fit the government guidelines. What if you owe or need a mortgage larger than agency loans limits? The answer is stay highly qualified. Highly qualified translates into high credit scores - try to get them above 720 or at least above 680 middle score. By now the industry seems to be doing a good job of educating the consumer on what a credit score is, how to protect it and how to get it. If you need assistance in this area I will be more than happy to take the time to consult on your credit situation and how to improve your scores. Part of the real estate market downturn, raise of foreclosures and mortgage lenders imploding is the State's Legislature is working on passing more regulations to protect the consumer. Recently for example the Attorney General of Massachusetts, Martha Coakley, has issued an expansion on Chapter 93A laws governing unfair and deceptive business practices with respect to mortgage lending effective at the beginning of January 2008. I cannot comment fully on this expansion but it has had an affect to keep potential lenders from doing business in Massachusetts and others to pull out of the State all together. It also affects the mortgage broker and lenders that have offered no income verified loans to its borrowers. The new expansion does not ban these loans but it has effectively eliminated a lot of the programs that would offer this reduced guideline. Therefore if you are self-employed or have income from various sources that you are used to expensing to reduce your tax burden - you will have a harder time getting a loan unless you submit the tax returns and hope to qualify for a mortgage loan.
Yes lending has tightened outside of government agency mortgage loans because there are effectively no buyers (investors) of private (non-government backed) mortgage debt. This will change over time and as a mortgage broker we have a high likelihood of finding a loan product to meet your immediate needs so call for a consultation. We know where to look.
There are still a lot of homeowners that think when the Federal Reserve cuts "The Rate" that this will automatically translate into lower mortgage rates. Let me define three key terms that you need to understand so you can assess the impact of the Federal Reserve's rate reduction.
The Discount Rate - is the rate at which The Federal Reserve's twelve regional banks lend money to their Member banks - normally for short periods of time up to thirty days, generally only overnight. This interest rate was cut by .75% or 75 basis points on January 22, 2008 to 4%. Typically the Discount Rate is 1% or 100 basis points higher than the Federal Funds Rate - at the moment it is only .50% or 50 basis points higher than the Federal Funds Rate.
The Federal Funds Rate - is the target rate the Federal Reserve sets in which private lending institutions (banks) lend money to one another - normally for very short periods of time, again overnight. This target rate was cut on January 22, 2008 by .75% or 75 basis points to 3.5%
The Prime interest rate - is the rate that banks lend money to their "Prime" customers, this rate is 3% higher than the Federal Funds Rate, therefore, as of January 22, 2008 it stands at 6.5%. The Prime interest rate is also used as an index for adjustable rate loans - generally second mortgage loans on homes and credit card debt. Therefore if you have a Prime based loan, then you will be directly affected by the Federal Reserve interest rate cuts. Further, when used as an index you will notice that there is a margin on the adjustable rate loans that can be a negative or positive percentage (this is a fixed percentage for the term of the loan). For example, if your Home Equity Loan is Prime minus .25%, the new rate will be 6.25% next month or if your Home Equity loan is Prime plus 1%, then your new rate will be 7.5% next month -- check the terms of your loan. In the case of some credit cards generally the rate is based on Prime plus a high margin.
Is there a relationship in fact when the Federal Reserve cuts these key interest rates? The answer is yes; the Federal Reserve, by cutting these rates, in fact is creating greater liquidity in the banking system as well as signaling the desire to have overall interest rates decline in the credit markets in general. The Federal Reserve has the ability to increase or decrease the money supply via purchasing or selling government securities respectively (open market operations) or cutting the key interest rates discussed above. The intent is to give the banks greater liquidity to lend money out - however if the banks don't lend then the policy will not have the desired effect. The general relationship to typical mortgage interest rates when the Fed cuts rates is negative. The reason for this is that the Equity Markets (Stock Market) typically favor a rate cut and therefore investors buy stocks on the cut and take money out of bond positions (selling mortgage bonds) that drive up interest rates. So in 2007 when the Fed cut its rates the typical 30 year fixed rate mortgage actually increased.
The greatest relationship to mortgage interest rates is the stock market. The wisdom is when the stock market sells off, the money flows to government guaranteed bonds thereby lowering interest rates. The fact is that the mortgage market is a market of buyers and sellers of the mortgage debt and interest rates have an inverse relationship to the price of the security - when money flows into the credit market (bonds are purchased) the yield or the interest rate paid to the purchaser decreases in direct relation to the price paid. This can be a confusing concept but the rule of thumb is if the stock market goes down in price so goes interest rates in the same direction -- down.
The current consensus is the Federal Reserve will continue to cut its key interest rates at the end of the month again and during subsequent meetings. The lowest the Federal Funds rate in the recent past has been 1%. We may be headed there again. If this happens, then we are looking at the Prime interest rate to be at 4% and this will make a lot of Home Equity loan holders very happy but at the same time their retirement savings will suffer so don't be too giddy.
I am committed to sound money management. I am a Registered Financial Consultant, RFC® and Registered Mortgage Advisor, RMA®. As the owner of Verdi Financial, LLC our clients are educated in unique sound principals of money management that are not taught by other financial professionals. Some of the educational concepts include: home equity management, retirement (Accumulation & Distribution), education, divorce, and most life event planning.
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