October, 2010
By Michael Kalscheur, CFP®
Senior Financial Consultant, Castle Wealth Advisors, LLC

Have you ever seen one of those descriptions of what has been invented in just the last 20 years? They talk about how 18 year olds now entering college don’t know what vinyl records are or how they have never heard of a Delorean, unless they found a “retro” VHS tape and watched an “old” movie called Back To The Future. By the way, that iconic movie came out in 1985; it’s 25 years old. Does that put things in perspective?

How will these same 18 year olds remember mortgage rates? 18 years ago (in 1992) you could borrow money for about 7.5%. This was right in line with historical averages, and much better than the rates just two years before that: 9.75% in 1990. Even that was a bargain compared to 10.75% in 1985 or 12.5% in 1984. However, mortgage rates hit their peak in late 1981: 15.8%.

Compare that to today’s rate: around 4.375% fixed for 30 years. Many people are getting even lower rates by taking shorter mortgages (15 year mortgages are under 4%) or taking out an adjustable rate mortgage (5/1 ARM’s are 3.125%). This is all with no points. Today you can buy your interest down to under 3%!

Caveat: You not only must have excellent credit to qualify for the best rates, but you must have 20% - 30% equity in your home. For many people who purchased their homes in the last 10 years, this is exceedingly difficult. That’s because most people put 5% or less down and financed the rest. Some people didn’t put anything down, or actually walked away from closing with cash in their pocket – a negative down payment. In 2007 the average down payment was just 2%; how’s that for perspective.

Under normal circumstances, where home values are increasing at a rate close to inflation, say 3%, putting a 5% down payment is not that big of a deal. That’s because within 4 years the mortgage balance will decrease and the home’s value will increase enough to give the home owner 20% equity. If values increase by 5% per year, it only takes 3 years to reach 20% equity.

However, most of the equity is determined by the growth in home values, not by paying down the mortgage. On the typical 30-year mortgage, after 4 years, 95% of the original mortgage is still owed. After 7 years, 90% of the original mortgage is owed. With a 5% down payment, and no growth in home values, it would take almost 10 years to reach 20% equity.

Unfortunately, the housing market has seen price drops the last few years, not increases. Most markets have seen drops in the 10% - 15% range, but there are extremely hard hit areas in California, Arizona, Nevada and Florida, where prices declined 40% - 50%. These drops have wiped out housing gains from the last 5 - 10 years. It’s no wonder that so many people find themselves underwater on their mortgage, or with significantly less than 20% equity needed to qualify for the best rates.

If you do have enough equity in your home, the question is not whether these are great interest rates or not (they are), but what is the best way to capitalize and increase your net worth by utilizing these low rates. There are two schools of thought here:

  • Borrow as much as you can for as long as you can. If you can borrow at 3% - 4% and reinvest at a higher rate, you could make a small fortune using someone else’s money.
  • Refinance at the lowest rate possible and pay your home off sooner. Reducing your interest rate from 5.25% to 4.25% will save $60 per month on every $100,000. Adding that money to the monthly payment can cut years off your mortgage.

There is an intuitive excitement about option #1, and understandably so. By borrowing money at a low interest rate and investing it at a higher interest rate, you get to keep the difference. It’s free money, what could go wrong? If you need an answer, this is called speculation, and is exactly what got us into the current mess that we are in.

Don’t get me wrong; if you want to purchase investment real estate, this is one of the best times in the last 30 years to do it. Prices are down and borrowing costs are rock bottom. Long-term returns should be very good. However, any time you borrow money you are magnifying your returns; both positive and negative. The more debt you take on, the more risk you take on. Right now, most people are not asking about how they can increase their risk.

Option #2 doesn’t sound as glamorous, but is fundamentally sound. Let’s say that you took out a $150,000 mortgage @ 6% in 2005. Your current balance is about $140,000 and your monthly payment (principal and interest) is $900/month. Refinancing to a new, 30-year fixed rate of 4.375% would lower your payment to $700/month.

You could take that $200/month and invest it, but what if you kept your payment the same? The extra $200/month would pay off your new mortgage in just over 19 years, almost 6 years sooner than if you didn’t refinance. Over the life of the loan you would save over $44,000 in interest.

Option #1 people would say, “but Mike, surely I can earn more than 4.375%. After taxes it’s like borrowing money at 3.5%. I can beat that.” Yes, you can, but that doesn’t mean you will. Where can you get a guaranteed 4.375% return on your money right now? Cash and money markets are paying 1% or less; CD’s are in the 2% - 3% range; 10 year Treasuries are under 3%.

Other kinds of investments that have higher rates of return involve more risk. Corporate bonds (interest rate & default risk), stocks and commodities (volatility risk) and real estate (liquidity risk) all have higher return potential, but can also decline substantially for long periods of time. Taking risks is part of life, but understand the risks before taking them.

Another idea, if you wanted to take some risk while still hedging your bets, would be to refinance your mortgage and use half of it to pay down debt while using the other half to increase your 401k contribution. That way you get a little bit of both worlds, and save some money on income taxes to boot (401k contributions are pre-tax and lower your taxable income).

We are in exceptional times for interest rates and mortgages. This is an opportunity for people with good credit and equity to significantly improve their financial position over the long-term. Prudent borrowing to purchase investment property can have great long-term results, while paying off your mortgage early can be a conservative alternative.

Michael Kalscheur, CFP®, is a Senior Financial Consultant at Castle Wealth Advisors, LLC. Castle specializes in helping families and closely-held business owners with strategies to protect and transition family assets from one generation to the next. Castle’s senior partners also work with clients throughout the country in making logical decisions to help them fulfill their personal and business financial goals. For more information visit www.Castle3.com, call 1-888-849-9559 or contact Michael directly at .