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Financial Planning > Tax Planning

The Bewildering Number Of Mortgage Choices

By Jim Connolly

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Boomers looking for help selecting a mortgage from the growing array of choices may find there are almost as many opinions among advisors on the matter.

However, a couple of general threads wove their way through all interviews: the choice of mortgage type is client-specific; it should examine assets and risk tolerance; and it depends on the number of years the property will be held.

Most advisors interviewed by National Underwriter favored a generally conservative approach. But there was a strong minority view that leverage, if used properly, could benefit the client.

Jeff Broadhurst, a financial advisor with Broadhurst Financial Advisors, Inc., Lansdale, Pa., says, “I believe that if a person has more than 50% of their home paid off, they should trade up to a larger house or pull equity out. All people, young or old, should own no less than 20% and no more than 50% of their principal residence. The bank should own the rest. Why? Positive leverage and maximum tax deductible interest. If you pay down your mortgage, you lose the benefit of positive leverage and reduce the amount of tax deductions.

“Actually, the optimal amount of equity in a home is 20%. That is why I like an interest-only loan with 20% down. The 20% down avoids mortgage insurance, and the 20% gives them a downside cushion,” Broadhurst says.

But, he also cautions that while leverage can work for a client, the client must maintain fiscal discipline. If a client can do that, then the funds can be directed into other assets such as a ROTH IRA, Broadhurst adds.

He says he likes interest-only mortgages (IOs) with longer terms such as 10-15 years because that is 2-3 times the average duration of the ownership of a home. If the average stay in a home is 5 years, he says, with a 30-year fixed mortgage, you are paying for 25 years of a guarantee you might not need.

In one case, he says he had a client with a 7.5% 30-year fixed mortgage and he had them close on a 10-year IO at 5.5%.

Dan Danford, president of Family Investment Center, St. Joseph, Mo., says he is comfortable with leverage, but his clients are affluent and the successful use of mortgage debt as leverage depends on the property’s quality and appreciation potential. “A good back door escape would be to sell the property, if necessary. If any of these things aren’t [or won't be] in place, I’d likely suggest a conservative mortgage approach.”

Nicholas Gibran, CEO and founder of Nicholas & Co. Mortgage Planners, Ann Arbor, Mich., says that about 65% of the mortgages his firm is closing are 5-, 7- and 10-year interest-only Adjustable Rate Mortgages, and the other 35% are deferred interest Cash Flow ARMs.

A cash flow ARM has several product features that can range from principal and interest payments to deferred interest features.

Nicholas says, “These loans can be dangerous in many situations but work very well in certain cases [such as a lower cost alternative to a reverse mortgage] so long as the home value reasonably can be expected to increase by a very conservative 1.5% per year [even less than the rate of inflation].

“The popularity of unconventional loans such as these points to the reason why financial advisors need to be learning actively about mortgage planning strategies and when these types of loans are suitable for certain clients,” Nicholas adds.

He notes that the use of mortgage options such as IOs and cash flow ARMs work better in regions where there is a strong economy and strong employment. They do not work with clients he calls “financial jellyfish”–those who do not have financial discipline.

But many financial planners are not as enamored of IOs and ARMs.

If an individual is going to be transferred in less than 5 years, then an ARM could make sense, according to George Middleton, a financial advisor with Limoges Investment Management, Vancouver, Wash. But, for periods of longer than 5 years, he would recommend a fixed mortgage.

Calling IOs “dangerous,” Middleton says “there had better be a realistic plan in place to attack the principle in the not-too-distant future. If people are expecting appreciation to bail them out, that’s a bad idea in my view.”

Elaine Scoggins, president of Scoggins Financial LLC, Tampa, Fla., says she believes as a financial advisor and a former bank executive who ran the residential mortgage department that the choice of mortgage depends on the client.

For instance, she says, a young boomer who might move for job relocation or to buy a larger home may find a 7- or 10-year ARM appropriate. The rate difference between an ARM and 30-year fixed mortgage can add up over time, she continues. Also, banks typically prefer ARMs over fixed products and offer low or no origination fees, Scoggins adds.

For older boomers getting ready to downsize, a 7- to 10-year ARM also can work, she says. And, for those staying in their home and nearing retirement, a 15-year mortgage can be useful if they can manage the payments, Scoggins says.

But she says she doesn’t like IOs unless a client has a very specific source of money coming for a down payment. “Often folks are using IOs with the hope that more down payment money will eventually fall into their lap from some unidentified source. This is something like playing Russian roulette with your home.”

Joel Ticknor, a financial planner with Ticknor Atherton and Associates, Reston, Va., says he has one client who will have such as source of income. At 50, this client took out an IO. Her income was stable and she knew she would inherit money in the future, he says.

But as chair of a local credit union, Ticknor also has concerns about mortgages such as IOs.

The good side is that people now can buy homes, he says, but the bad side is that they are, in effect, borrowing money to make a down payment. “A lot of people will be hurt when the downturn comes,” he adds.

“Many are attempting to buy bigger houses and more luxurious apartments,” he adds. “They are counting on not being the last guy to buy the house.”

But a traditional mortgage at today’s rates offers a bargain if rates rise, he says. If they fall, a client can refinance, Ticknor adds.

And, according to Eve Kaplan, a financial planner with Kaplan Financial Advisors, Berkeley Heights, N.J., a fixed mortgage offers the option of accelerating payments. But Kaplan expresses caution about ARMs. If inflation rises, the amount a mortgage holder is paying is declining in real terms, she says.

Lower rates are “wonderful” because they have made it possible to move up to a nicer home, but things also can be taken too far, according to Patrick Doland, a financial advisor with Reason Financial Advisors, Northbrook, Ill. “If a man’s home is his castle, he needs to be able to defend it.”

Doland cautions that “if real estate values are correct in some of the more popular areas of the country, a 10% or 20% drop in valuation will result in many individuals losing all the equity in their home…and potentially even their home.”

He adds that flipping property is a sign of ‘irrational exuberance.’ “Fixed rate mortgages never got anyone into trouble, especially if they plan on staying in their home for at least five years.”

Of IOs, he says they can work for high income individuals who want to match principal reductions with cash flow. When used properly, “they can be extremely effective.” But for the average individual, an IO can be “a ticking time bomb.”

And, for younger boomers who might want a bigger house in the future, there will be less equity to use, he notes.

He says he is concerned about regions such as Florida where people are making commitments to buy a condo and selling them before they are completed–”flipping.” This is a “warning sign,” he says.

Cary Carbonaro, a financial advisor and founder of Family Financial Research, Clermont, Fla., says most of the mortgage clients are choosing IOs. “We are not even seeing ARMs,” she says, adding there is little interest in traditional mortgages.

The trend worries Carbonaro. “People are speculating like crazy.” She adds that she does not know what people think the reality is if the real estate market falls and the “get rich quick” mentality fails.

She says she tries to educate clients and talk to them about net operating income and looking at real estate in an objective way.

John Gay, a financial advisor from Frisco, Texas, sees a different picture. He says his clients are “the millionaire next door” but very low key, “salt of the earth” people who don’t want people to know they have money.

Their sensibility is to use a more traditional 15- or 30-year mortgage, he adds.

Consumers feel that IOs allow them to use what would be home equity for other purposes, he says. But “home equity always can be tapped at a later date. I’d prefer it to be later than sooner.”

Gay believes it is sensible to have the mortgage end when the person stops working.

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