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Posts Tagged ‘mortgage’

Understanding Liquidity

February 5th, 2010 No comments

In this post I talk about liquidity and how to use it in your own finances.

The idea for this post came from one of my friends who is making a pretty large error in his personal finances. He is borrowing one of Suzie Orman’s big ideas: pay off your mortgage as soon as you can by prepaying principal and once it is paid off leave it un-leveraged. This isn’t a bad idea in itself, but he is structuring his finances toward this goal to the detriment of other parts of his financial life.

The other big issue in his life is his job security. Over the past few years, his job has been under threat due to global competition which has increased his anxiety as well as resulted in lower job quality and smaller pay over time. He is working on this issue by getting a certification and actively using his network to plan ahead for the next position (this is good).

This is the second time around, though this time he hasn’t been laid off yet. The first time he was laid off, his savings plus unemployment would have lasted about 6 months before his cashflow was an issue. Fortunately,  he found a job in about 3 months.

What happened after the first layoff is where the problem re-develops. What did he do? He continued spending after getting the next job, including a bunch of (borrowed) money to improve his home plus miscellaneous spending. He’s paying down his mortgage with additional principal. It’s been a number of years later and he still really hasn’t improved his financial situation. He is still vulnerable to a job loss.

There is lack of understanding or actually a lack of will on his part to address his situation and see how he can improve it. I don’t want to address the psychological issues, but the finance issues. Even though on paper his net worth is increasing, the steps he is taking has reduced his financial liquidity, which is the ability to generate cash easily without a reduction in asset value (selling for a loss, or below market price).

The damage a lack of liquidity can cause can been seen by what has happened over the past year in the economy.  Many companies are failing due to lower cash flows that aren’t covering debts, along with a broken credit market that has limited the ability to refinance the debt.

Using my friend as an example, these are the steps he could take to increase liquidity. Increasing liquidity would help to reduce his anxiety by increasing his ability to generate cash and increase cash reserves.

Sell The House

The psychological need to payoff the house is driving his anxiety over his job situation. This anxiety could be eliminated if he simply sold the house and rented an apartment or home. Instead of being on the hook for say, a 20 year mortgage, he would only be on the hook for an apartment lease of, say, 1 year. Also, the equity he would realize would be cash in his pocket. This decision would leave him in the most liquid position.

Refinance to a Longer Term

In my posts that gave you tips to refinance a mortgage, I talked about how to save money by reducing the total cost of your mortgage.  If you want to save the most money on a refinance, you would take a new loan with a shorter term. If you want to increase liquidity, you would want to do the opposite and take on a new loan with a longer term. This new loan would free up money each month because it will have the lowest payment. See Example #1 in the calculation post.

Stop Prepayment of Principal

When you pay extra money on your mortgage above the monthly payment, this reduces the total cost of the mortgage. However, this doesn’t affect the payment each month, it still remains the same. So this reduces your liquidity.

Don’t Fund Home Improvements

Paying out money to improve the home is less money available to pay the mortgage in the future. Even worse, he borrowed additional money to pay for the improvements which effectively increased his mortgage payment.

Spend Less, Save More

If he improved his cash flow by spending less, he would have more money available in the future to handle any income interruptions. He does not  plan spending or have a budget.

Summary

When looking at your own finances, you need to evaluate your own financial situation and make the appropriate adjustments to find your optimal comfort level.

Categories: Investing Tags: ,

Save Money Refinancing a Home Mortgage, Part II

January 16th, 2010 No comments

This is the continuation of the first post. For the calculations in this post, the following loan will be used. If you want to use your own loan information, collect the following information: 

  • Annual Interest Rate.
  • Monthly Payment.
  • Number of Months Remaining: Subtract months you have paid from total months (e.g., for a 30 year loan after 5 years, this works out to 30*12 – 5* 12 = 360-60 = 300).
  • Current Loan Balance – find this on your current statement. 

Sample Loan: 30 year mortgage that has 25 years left to go:

  • Loan Amount: $200,000 
  • Term/Annual Interest Rate: 30 years/6%.
  • Monthly Payment: $1200 (rounded up).
  • Number of Months Remaining: 300 (25 years).
  • Current Loan Balance: $186,000.

The following Yahoo! calculators will be used:

Example #1: Refinance to 30 Year, 5%. 

Input the existing mortgage information into the RC. (Use the values above and input them into the calculator inputs of the same name). For the new mortgage, specify an interest rate of 5%, 360 months. Use the default closing cost estimate of $2500, and origination costs of ZERO. 

The calculator not only gives you the 30 year re-fi, it also provides the new payment for a mortgage modification loan (this is referred to as an ‘Enhanced Refinance’). The 30 year loan saves you almost no money in interest costs, while the mortgage modification saves a lot more: 

  • 30 year loan saves: $64 dollars (new payment: $998 – the lowest payment).
  • Mortgage modification saves: $33,316 (new payment: $1087).

Example #2: Refinance to 20 Year, 4.875%. 

Input the existing mortgage information into the RC. For the new mortgage, specify an interest rate of 4.875%, 240 months. Use the default closing cost estimate of $2500, and origination costs of ZERO. 

The Enhanced Refinance result is not relevant in this calculation.

  • 15 year loan saves: $67,990 (new payment:  1,215 – slightly higher) .

Example #3: Refinance to 15 Year, 4.75%. 

Input the existing mortgage information into the RC. For the new mortgage, specify an interest rate of 4.875%, 240 months. Use the default closing cost estimate of $2500, and origination costs of ZERO. 

The Enhanced Refinance result is not relevant in this calculation.

  • 15 year loan saves: $99,102 (new payment:  1,447 – much higher) .

Summary 

  • The best value is the 20 year re-finance. It saves money and the payment is only slightly higher.
  • The 30 year mortgage modification saves both in total cost and the monthly payment.
  • The most savings is found in the 15 year refinance, at a much higher payment.
  • The 30 year refinance lowers the payment the most, but there is no savings here (actually a loss) if you also add in closing costs. 

Save Money Refinancing a Home Mortgage, Part I

January 15th, 2010 No comments

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As I write this, mortgage rates have come down significantly due to the actions of the Federal Reserve and the U.S. Treasury.  They have come down very fast.  This has created a frenzy in the market. Whenever dislocations in a market like this happen, watch out. There will be many more applicants than mortgage brokers to handle the volume which means that the brokers have incentive to hold out for the borrowers who will pay the most.

As Jack Guttentag writes, pricing is all over the board. Before you call the broker, you should have a good idea that a refinance will actually save you money. Mortgage brokers are salespeople and they are selling you a mortgage, they will often times try to convince you to buy even if it isn’t in your self interest.

In this post I will talk about some things you will want to consider. In a followup post I will go into detail using a sample mortgage and an online calculator.

First, What Your Broker Doesn’t Want You to Know

The mortgage broker doesn’t want to tell you that you should go back to your existing mortgage holder and ask for a mortgage modification. This is as close to a free lunch as you can get in the mortgage market because in addition to a rate reduction, they will keep the existing terms of your mortgage including the term. This means that all the equity you have been building in your payment (the percentage that goes to principal) will be maintained instead of starting over with a new mortgage.

The banks know this is a good deal, so you will likely get a new interest rate above fair market rates. This is OK, you will likely still be better off particularly if you have more years of your mortage paid off already.

Some years ago, I refinanced a mortgage this way. The only thing that changed was the rate (it went down 1%), there were no closing costs at all and the principal was the same (they didn’t roll closing costs into the mortgage). Due to the existing credit crisis, banks may not give these deals anymore so don’t be surprised if there are some closing costs.

Look at Total Cost, Not the Payment

I get annoyed at mortgage brokers who try lots of different schemes to get your mortgage payment down without considering if the mortgage will actually save you money over the entire term of the mortgage. There are a couple of ways they try to do this: offering a mortage at a longer term and rolling closing costs into the mortgage.  If you have paid off 5 years of a 30 year mortgage, a refinance will restart your mortgage back to year 1. Even if your mortgage rate stays the same, the mortgage payment will go down because the term was increased. Closing costs added to the mortgage will not affect the payment significantly since it is amortized over the term, but it increases the total cost of the mortgage.

The broker will try to distract you by giving you an estimate of how long if will take to payoff the costs of the new loan using the ‘savings’ from the lower payment in the new loan. Don’t fall for it. Run the mortgage in a calculator to determine the savings.

Consider Interest Rate and Term

The goal of your refinance should be to reduce the total cost of the mortgage. A loan that costs less will let you keep more money in your pocket. Even if your interest rate drops 1%, you still may not get a new loan that will save you money, if you restart your term. If you are in this situation, consider dropping the term on the new loan. For example, if you are 7 years into a 30 year loan, consider refinancing down to a 20 or 15 year mortgage. This will let you keep all the ‘payment equity’ you have built in your existing 30 year loan. If your interest rate drops and you decrease the term on the new loan, it will be very hard not to save money.

Sorry to give you the bad news, but saving money on your mortgage will likely mean a larger monthly payment. This is easily seen when comparing a new 15 year loan versus a new 30 year loan. The monthly payment needs to be larger on the 15 year loan primarily because you are paying the principal down sooner. The quicker you pay off principal, the less interest that is charged.

In Part II, I demonstrate what was discussed here using online calculators.

Shortcut: Using a Mortgage Factor

January 13th, 2010 No comments

Quick, you want to know what your mortgage payment will be on a $200,000 house at 6% on a 30 year mortgage. This is quite easy using a shortcut that I call a mortgage factor.

Here’s how it works:Take the mortgage amount, drop the thousands (in this case 200). Multiply this amount by the interest rate (in this case 6). And there you go: (6 * 200 = $1200/month).  Believe it or not this will calculate it correctly within a couple of dollars! It also works in reverse, if you only want to spend $1200/month what will be the maximum amount you can borrow? Simply divide 1200/6, and you get 200 (multiply this by 1,000).

This also works for rates of 5% and 7%, but it is less accurate. (Multiplying by 7 will give you a payment that actually is closer to 7.5%; while multiplying by 5 will give you an interest rate that it closer to 4.5%). It can still be useful to give you a ballpark figure.