How Low Can You Go?

by Michael Eastham, CPA CRMS

“It’s amazing, it’s incredible! For the low, low rate of just 1.95% you can buy the home of your dreams!”

I’m sure you’ve seen ads like these, offering mortgage rates that even go as low as 1%. Is it too good to be true? Well, maybe it is. It is no secret that lenders spend tens of millions of dollars fighting over your business. As with anything, it is up to you, the buyer, to do your homework and educate yourself about the largest financial commitment that you will make in your lifetime. Let me dispel one myth right at the outset: lenders are not going to lend you money for less than it costs them. Sorry to burst your bubble, but it is my job to inform and educate borrowers, so that they understand the nature of their commitments prior to signing on the dotted line.

As for the low rates, there are several ways that a lender can advertise these rates without violating any laws. Many lenders offer an interest rate as a teaser or an enticement to you. It is like the low rate mailers that you receive from your credit card company offering you “0%” financing for six months on balance transfers. It is a hook to get you in the door. These companies know that statistically, most people will keep the balance well beyond the introductory period, and will end up paying 15-24% on their purchases. It is exactly the same for mortgage lenders. They know that once you commit to the loan, you belong to them for quite some time. In fact, it is not unusual for some of these loan programs to have prepayment penalties that preclude you from refinancing or selling for a defined period of time, thus insuring they will receive adequate return on their investment. Such loan programs will typically provide the teaser rate for 3, 6 or 12 months, jumping up to the fully amortized interest rate. That can be an eye widening surprise if you are not prepared for it!

Another way that lenders advertise these low rates is to present the rate as a payment rate. This is not an interest rate at all, and has nothing to do with the interest that is charged. Quite simply, what the lender does is present a rate, representing a monthly payment that is lower than the actual interest rate charged. For example, on a loan amount of $250,000, a lender may charge an interest rate of 5.75% that equates to a principal and interest payment of $1,459. However, your minimum payment may be based on 1.95%, which equates to $918. Do you see the attraction? Now, here is the rub: the minimum payment is similar to that of a credit card. If you only pay your minimum payment, it could take you 30 years to pay off a rather small balance. In fact, using this example, the mortgage balance will increase.

Before you dismiss this type of a loan option completely, I must say that I am a big proponent of employing this kind of loan for the right person using the right strategy. Many of these loan programs are called “option arms” and they can provide the prudent investor with some significant benefits.

For example, if you have a job where your income fluctuates for whatever reason, this program gives you the ability to adjust your payments monthly, based on your cash flow. Usually you are given three to four payment options from which to choose each month. One is the minimum payment as described above; another is an interest only payment; third, is a fully amortized payment based on 30 years; and fourth is a fully amortized payment based on either a bi-weekly payment or 15-year amortization. As you can see, this type of flexibility is typically unheard of when you lock yourself into a traditional 30-year or 15-year mortgage.

Another example is if you are able to invest your money in better vehicles, instead of the equity of your home. If you can, you should remember a few things:

1. The appreciation of your home is not affected by the amount of your mortgage.
2. If you are able to invest the difference between your mortgage payment and what that payment would be on a traditional mortgage, and receive a return that surpasses the after tax cost of the interest rate you are paying, you will benefit tremendously from a strategy that I refer to as the velocity of money.
3. The equity in your home has no return on investment if it sits there.

It is also very important for you to understand that these loans are adjustable rate mortgages. The adjustment period can vary significantly depending on the loan program you are considering. As with any adjustable rate mortgage, the underlying index has a significant impact on the stability and vulnerability of the interest rate that you will be paying (that is a topic for another article, stay tuned). Finally, whenever considering a strategy such as that described here, it is critical that you employ prudence and discipline, and involve the counsel of trusted advisors, such as your mortgage broker and financial planner.

Remember, we live in a world where marketing is a powerhouse that is designed to seduce us with its superficial appeal and can pierce common sense and knowledge. It is up to you to get educated and discern whether a particular loan program is right for you.