New Opportunities and Pitfalls

Asking the Right Questions & Offering Trusted Advice

Originators are becoming aware of how important a home loan is to a family’s overall finances. Choosing a mortgage should involve more than picking the lowest rate. Instead, a household’s budget and plans also need to be taken into account. A loan officer who asks questions before recommending product can become an important professional advisor.

Here are some questions to ask.

How long do you expect to live in this house? Someone who plans to retire out of state, or anticipates being transferred with a few years obviously doesn’t need a 30- year, fixed rate loan.

Follow up this initial question by probing specifically: 

Do you anticipate having another child, and needing a bigger house?

Will you want to move into another school district once your toddler enters first grade, or your older children are ready for high school?

What’s the likelihood that another family member- an aging parent or young adult- will move in with you?

Will your income change in the future? Perhaps one spouse will go back to work once the children are in kindergarten. Or someone in the household could be learning a trade or finish a degree program, and should soon have a better job. You can feel more secure recommending an ARM to someone whose cash flow should be greater in the future. But if someone tells you that the next year they’ll stop receiving alimony, make sue their mortgage payments still will be affordable then.

How will your expenses change in the future? Find out if car payments or child support expenditures will end soon, or if a student loan is about to be paid off. Additionally, ask if anyone in the family anticipates rising medical expenses in the future.

Brokers also have found they can play a beneficial role by helping consumers to restructure their debt. Often it’s possible to lower payment and increase3 tax deductions by using a home equity loan or credit line to pay off charge cards or fiancé a vehicle purchase. Payment options can be used to manage cash flow, as well. Today more loans are offering a variety of choices, including a minimum payment with possible negative amortization, an interest-only option, and several amortization plans.

All of these tools have their uses. But it’s important that mortgage brokers- especially if they want to be viewed as financial advisors- are aware of the pitfalls different financial strategies offer. It might be useful to remind some in who is applying for a home equity loan to fund a vacation that they’ll spend years paying for that trip. Tell them that a good rule of thumb when borrowing is to make sure they will still be benefiting from what they used the money for once the loan is paid off. Based upon that principle, it can make sense to borrower in order to buy a house, make home improvements, purchase a car, or apply for a college education.

Bet the Ranch 

One piece of advice some mortgage and financial advisors have been suggesting in recent years is to take out as much home equity as possible. “Dead equity” sitting in a house is useless, they argue. Borrowing against equity in order to buy a second home, or invest in stocks, is touted as a better idea.

Believing that a certain financial strategy never fails allows advisors to claim that it’s always best to pursue it aggressively. Yet a central concept in financial planning is to match strategies to each individual client’s needs. Most investments have their uses, but adopting a “one size fits all” approach will be harmful to some clients. History shows that stocks will outperform bonds over time. But you don’t put all of Grandma’s money into stocks, simply because they’re “always a better investment” Why? Because you know Grandma is living off her portfolio and if we go into a bear market the value of her holdings will drop. Yet someone who is young can take more investment risks, since they have many working years to gain back any short-term losses.

Financial planners recognize that risk and reward are related. And they know that no one can accurately predict the future. For that reason, investments are diversified. That portfolio mix is chosen given an individuals’ life situation. Latching onto one idea-that stocks always will go up- and pursuing it relentlessly eventually will result in disappointment.

Taking out a home equity loan to invest in stocks could be beneficial for some, but it’s also risky. Only someone with adequate patience and cash flow to cover both their mortgage and home equity loan no matter what happens to the underlying value of their house and stocks should consider it.

Michelle Singletary, personal finance columnist for The Washington Post, recently wrote that “homeowners have been asking whether I think it’s a good idea to refinance or to obtain a home equity loan or line of credit (secured by their homes), for the specific purpose of investing in securities (stocks and bonds)”. She responds, “The short answer is: Don’t even think about it. Make no mistake about this: When you use mortgage money to buy securities, you aren’t investing, you’re gambling”.

Now that seems like strong words, especially sine stocks typically will rise in value faster than real estate will. Yet Singletary notes,” this plan might work, but only if everything goes right. But does everything always go right when you’re investing” She ads that the National Association of Securities Dealers (NASD) states; “This type of recommendation is inappropriate for almost everyone” NASD recently started three enforcement actions against advisors who urged clients to invest their home equity funds.

You’re fired!

Debts of $1.8 billion triggered the recent bankruptcy of Trump Hotels & Casino Resorts Inc. High interest payments meant The Donald couldn’t invest enough in his Atlantic City properties to keep them competitive. It shows that excessive borrowing can be a two-edged sword, even for experienced investors like Donald Trump. Although leverage increase the potential rewards, it also can hasten insolvency.

Bill Gross, managing director of PIMCO, understands the risk. He started his company, which is the world’s largest bond investment management firm from blackjack winnings. Gross was one of the first card counter, and his willingness to bet large sums have contributed to PIMCO’s rise over the years.

Yet recently he discussed the risks of excessive leverage today, specifically with regard to hedge funds. Instead of purchasing shares of a company, a hedge fund may bet on the market wit an S&P futures contract. A $1 million position in stocks can be gained with an investment of just $20,000.00 to $40,000.00, due to the leverage available from futures. Similar positions can be taken in Treasury bonds and commodities using futures contract. Gross describes “the inherent fertility yet potential destructiveness of leverage” that at times leaves investors “watching your equity disappear”.

Unwind at Home 

Borrowing against a home’s equity increases the debt on an already- leveraged purchase. A house is bought mainly to provide shelter, even though it generally offers financial security as well. Yet that security comes from unwinding the leverage, rather than intensifying it. Paying off a home loan improves a borrower’s cash flow- and that allows folks to retire, invest, or do whatever they want with their funds. Equity in a house also makes moving up to a better residence easier on the budget.

Additionally, some advisors believe stock market returns will remain below normal for the next several years. That means returns projected by today’s eager investors may not occur. History shows the stock market can rise quickly, only then to stay in a trading range for decades. Investors will recall that much of the 1960; s and 1970’s were low-growth years for stocks. 

Equities raised in value an average of 13 percent annually fro 1950-95, according to Bank Credit Analyst. But during the bubble years of 1996-99 they went up over 27 percent annually. Getting the market back to its historic rate of return will mean stocks return less than 8 percent per year from 2002-12.

However, other experts say that increased productivity allows companies to be valued at higher levels today, and thus to deserve elevated stock prices.  Although there’s some merit to that argument, it’s also a double-edged sword. Mortgage brokers know they can produce a lot more loans with fewer people now than was possible 10 years ago. Although that helps your productivity and profits, it means fewer people are hired.

Today’s economy illustrates that effect, as strong corporate profits are offset by tepid hiring and wage increases. Most previous recoveries saw robust job creation, followed by higher inflation as companies competed for scarce workers. So far that hasn’t been the case since the 2001 recession.

Risky Perspectives 

An ethical guideline for investment advisors is the “prudent man” rule. It asks whether a prudent person- an objective outsider- would approve of investments that are being suggested to clients. Cultivating that attitude is crucial for success as a financial advisor. Yet financial advisors also are usually salespeople- and their interest in making another sale can cloud their judgment.

At times advisors aren’t aware of their own biases. For instance, many home loans have been sold on the basis of” I can lower your monthly payment”, or “I can give you some cash”. Consumers enjoy hearing those benefits, and at times those solutions are exactly what’s needed. But make sure that’s the case before proceeding. Someone who plans to stay in their home may be better off paying off their existing home loan, rather than refinancing and stretching out lower payments over a longer period. Or a household that wants to use its home equity to put in a pool may be stretching their budget too far. A Trusted advisor will discuss this issue with client, rather than simply chalking up another sale.

It’s helpful to leave some slack in a household’s cash flow whenever possible, since unforeseen events create unavoidable expenses. Routinely encouraging folks to maximize their leverage means households will be exposed to additional financial risk. Yet only persons who can handle extra financial risk should be employing riskier strategies. Most consumers are awar3e of this. First time buyers typically prefer a fixed-rate loan, while jumbo loan customers with financial reserves feel comfortable with monthly-adjustable ARMs.

Ultimately customers decide how to arrange their finances. One homeowner may be comfortable using an equity line for a vacation home down payment, because he’s worried that future price rises would make buying harder. Yet others may believe that today’s real estate market is overheated, and will want to sell both their primary residence and second home in order to move into a smaller house, and have money left to invest.

A financial planner’s job is to show clients the risks and potential rewards of various strategies. Professional advice is helpful when you both understand the needs of specific customers, and can explain the implication of propose actions. You’ll become invaluable, and gain a great reputation when you creatively craft positive financial solutions that have a high probability of working over time.

Consider a mortgage broker who contacts homeowners with children who are about to graduate from high school. Some may want an equity loan to pay for four years at StateU. But others may be better off borrowing less, and having their child spend the first tow years living at home, working part-time, and attending a nearby junior college. Letting the needs of each situation dictate your advice is one sign of a professional who is earning client’s trust.