I recently received the following question from Steve Farnsworth of Adamarc Financial Company of San Francisco, and I thought it might be valuable to everyone not only to answer it myself but to gain insight from a few industry leaders.
The question was:
“In your Oct. 22 blog, you note the option of getting a lower payment by choosing a short-term loan — let's say a 5/1, instead of a 30-year fixed. I have had three clients in the last 30 days respond, “But if I take a shorter-term loan, I will have to refinance in five years and rates might be higher. Doesn’t that make this strategy risky?” … [and] Is there a way to answer this question or to inoculate against it by using a script/set-up in advance?”
I will address the last question and leave the longer explanations to my guest respondents, below:
My response:
There is a way to generate a consistent and positive response to this last question, by using a Mortgage Coach Total Cost Analysis report. In the second section of page one, you can input the data from four loan options and display them side by side for comparison, showing your client the potential total cost of each loan type over time. As you walk through the costs and risks of each example, it should become clear to your client which one will be the best fit for them.
Todd Ballenger, CEO of KendallTodd Inc., responds:
Your question of product is really a question of risk management. It’s an extremely important consideration that only can be answered by asking the client ‘how long do you plan to either live in this house, or keep this specific loan’? The product — what we refer to as Step 1 in our 7-step process — is the specific period of time that the client will want interest-rate protection; and their specific need for that protection is relative to the shorter of either 1) their time in the house, or 2) their expected need for their specific loan.
Let's consider an example. Assume your client expects to be in this house for about five years. In this situation, the useful life of the loan is five years. Paying for interest-rate protection beyond the 5th year is like heating the house with the windows open. If the 30-year fixed rate is 6.5%, and the 5-year ARM is 6.0%, the 1/2% savings is the reward for managing the risk in a smart way. The client isn’t concerned with the rate adjusting in year six because they don’t plan to be there in year six. You can help them further bracket their decision by asking if they are typically conservative, moderate or aggressive when it comes to taking interest-rate risk. If they answer conservative, you can extend the five-year to a seven-year product to provide two additional years of protection, just as an ‘aggressive’ response might justify a three-year ARM product.
The key here is one of suitability for the client, which can only be discovered through asking questions and then clearly illustrating for them the financial impact of their reward. Their $200,000 mortgage at 6.5% interest only would require a payment of $13,000 annually. The $200,000 mortgage at 6.0% interest only would require a payment of $12,000, almost an 8% reduction in their overall annual interest cost. That $1,000 annual savings ($83 a month) could be used to more quickly retire the remaining debt (further decreasing their interest-rate expenses), or to fund other investment products or services that might be identifiable by a financial advisor.
If your client truly believes they will keep the loan for 30 years, then a 30-year fixed product may be the alternative that helps them sleep better at night. While they won’t change their mind, they may be open to a new decision if you present them with a list of ‘mental triggers’ that might showcase the unlikelihood that they'll be in that same house, or financial instrument for 30 years. Ask them to consider how a new career, death of a family member, decrease in interest rates, an inheritance, children attending college, illness of a parent, a future empty nest, children finishing college, their retirement, nursing care, or a new mortgage product might influence their decision to stay put with one house and one loan product for 30 years.
Asking these questions might influence their decision to keep a 30-year fixed product, because a refinance or sale of the house will end the useful life of that original mortgage product and clarify why they might consider a shorter-term period of interest-rate protection. At the end of the day, it isn't about selling a shorter-term product, it’s about good risk management coupled with great client communication.”
Ron Quintero, CEO of Debt Advisory Alliance, responds:
“Before prescribing a loan for anyone, one needs to examine the client’s overall long-and short-term goals and make recommendations that fit their profile and risk tolerance.
Consider these statistics: The average loan stays on the books 4.1 years. About 26% of all loans are removed from the books every year. Less than 2% of all home loans made are ever paid off with the person living in the property free and clear. But what if your client is in that 2%? Then they should probably be in a 15-year fully amortized loan on a bimonthly payment program. Now before you throw back at me the “Doug Andrew Missed Fortune” or “Steven Marshall Strategic Equity” rap, I get it, I know it, I live it, I have a 40-year option ARM. But that doesn't mean that strategy is right for everyone. I NEVER EVER plan on paying off a home. I rarely live in one for more than a few years.
Dave Savage taught me a few interviewing questions a long time ago to profile and discover the customer’s wants and needs. One of my favorite questions is, “Do you plan on paying off this property and enjoying it throughout your retirement or is this a home you are living in to accommodate your family’s current needs and your present life style?” Perhaps they are becoming empty nesters in the next year or two and plan on downsizing, moving to a different community, etc. and in that case it may make sense to do nothing at all.
The prepayment for my loan expires next month and I will refinance to reboot my deferred interest, reboot the recasting time clock, pay for my property taxes in the process (about $22,000 a year) and harvest one or two years of payments and pay for my household mortgage from the equity. Hell, I haven't made a direct monthly payment on my primary residence in over five years and I don't plan on starting any time soon. (By the way, with this strategy, I double my tax deductions, and I’ve written a piece for Mortgage Planner magazine explaining the concept; so watch for it — I hope you subscribe; if you don’t, let myself or Dave know; we’ll make sure you get a copy of the article).
Without a doubt, there is always risk when dealing with finances. Sometimes the absolute riskiest thing one can do is nothing. There are no perfect solutions. We present ideas, let our clients know the possibilities, and once they are fully informed, THEY make the final decision.”
Thanks Steve for bringing up the question, and thanks Todd and Ron for providing your expert viewpoints!
Also, I recommend that you check out these additional sources. Both the article featuring Angelo Mozilo below and the Harvard University Study validate Todd’s point that more than one-fourth of your database will be ready to refinance every 3-4 years.
To read the Los Angeles Times article:
http://davesavage.typepad.com/CountrywideArticle.pdf
To read the Harvard University Housing Study:
http://www.jchs.harvard.edu/publications/markets/son2006/son2006.pdf
Chart from Housing Study:
http://www.jchs.harvard.edu/publications/markets/son2006/son2006_appendix_tables.xls
To reach Todd Ballenger:
[email protected] or 919.309.9078
To reach Ron Quintero:
[email protected] or 949.360.7001
To reach Dave Savage:
[email protected]
To subscribe to or learn more about the new Mortgage Planner magazine: www.MortgagePlannerMagazine.com/MortgageCoach
