Opinion

Felix Salmon

How to funnel money to bankers and brokers, housing edition

By Felix Salmon
March 9, 2011

Linda Stern has replied to my post about her dreadful advice to leverage up as much as you can to buy a house right now. And she’s not backing down:

My job is to write about what’s good for the consumer, not the bankers and brokers. And, for a young person who wants to own a house, the numbers say it’s better to squeeze together your 3.5 percent down payment and lock in a 30-year fixed rate loan now, at 4.87 percent (with deductible interest).

Got extra money? I’m guessing a nice balanced mutual fund will do better than 4.87 percent over 30 years…

And if you banked your cash instead of tying it up in your house, doesn’t that give you more leeway to pay your bills while you sort out your finances?

The line about “what’s good for the consumer, not the bankers and brokers” is truly astonishing. The argument here, if you don’t want to follow it back to the beginning, comes down to a simple choice: do you buy a house now with very little money down, or do you save up for a larger down payment? Linda recommends the former course of action, I think the latter is much more prudent. But what’s undeniable is that bankers and brokers will end up making much more money if you follow Linda’s advice than if you follow mine.

After all, the more that banks lend, the more money they make. If you maximize your borrowings, as Linda recommends, that’s extra profit for the banks. On top of that, Linda reckons it’s a good idea to use any excess cash not for your down payment (which would lower the amount you have to borrow and therefore lower the amount of money the bankers make) but rather for long-term investment in “a nice balanced mutual fund.” Which of course means profits for the fund managers and stockbrokers involved in selling you that fund. And we’re not done: the house you buy will probably be sold by a broker, who will profit 6% or so of the sale price. More money going to intermediaries.

And has Linda forgotten this bit, from her original post?

To get one of those 3.5 percent down payment loans, though, borrowers have to pay one percent up front and annual mortgage insurance premiums. Beginning on April 18, those premiums will rise 0.25 percentage points, to 1.1 percent for borrowers who put at least five percent down, and to 1.15 percent for borrowers who only put 3.5 percent down.

That’s 1.15% of the value of your mortgage every year for 30 years — all going directly to insurance premiums, which are a crucial part of the financial-services profit machine.

So if you want to do what’s best for the financial-services industry, and for bankers and brokers, you should definitely follow Linda’s advice.

Meanwhile, Linda does seem to be a bit fuzzy on what exactly you should do with the money you don’t put towards a down payment. On the one hand, she says it should be tied up in that mutual fund for the next 30 years, in the hope that it will return more than 4.87%. But on the other hand, she says that it should be “banked” so that you can “pay your bills.” Well, you can’t have it both ways. If you want the cash to be liquid and available for bill-paying, you shouldn’t invest it on a 30-year time horizon. (After all, as we saw during the crisis, people have a tendency to need cash at exactly the time their investments plunge in value.)

As for Linda’s “numbers,” I’m completely unconvinced that there’s any clear math showing that buying now makes lots of sense. Linda’s argument is based on speculation about the future — that interest rates and house prices are both going to go up over the next five years. That’s possible, of course. But it’s hardly an obvious mathematical truth. In recent years lots of people have lost lots of money by making exactly that bet. Which would seem to indicate that a bit of prudence, and saving up money for a decent down payment, makes a lot more sense than a speculative plunge into a highly-leveraged and extremely illiquid asset.

Comments
21 comments so far | RSS Comments RSS

At 50, I qualify as an old guy, and the smartest thing I’ve done through the years is maximize liquidity. It prepares you for financial calamities like 2008, but, more important, it gives you the flexibility to change your life when you need or want to. That has been far more valuable, both financially and emotionally, than any gain in net worth I have foregone.

Posted by RZ0 | Report as abusive
 

Okay, since when does maximizing risk good for the consumer? We tried that trick in the last decade, and millions of consumers are the worse for it. As my friend Rocky the Flying Squirrel said on many occasions, “Bullwinkle, that trick never works!”

Posted by Curmudgeon | Report as abusive
 

I don’t believe there is blanket advice that will be optimal for every consumer – there are so many variables that affect the rent vs. buy decision, that you can’t just say one is right for everybody. But what I will say is bad for the financial system is a return to low or zero down mortgages – injecting that kind of risk into the debt markets creates too much instability. Unless, of course, we can have high inflation with low unemployment.

Posted by KenG_CA | Report as abusive
 

Felix – Linda is making two different arguments at the same time:

1) that you should try to buy a house now with a minimum down payment instead of saving (which I think is crazy) and

2) that if you have enough for a larger downpayment, you should STILL make the smaller downpayment and essentially try to arb your cost of funds (which is probably bad advice for 95% of Americans, but it is indeed open for debate).

I think that’s what you need to focus on in trying to discuss this further with her.

Posted by KidDynamite | Report as abusive
 

Note that the lock-in value of a fixed rate mortgage only extends until you sell. If you buy now and hold for 30 years, you might come out ahead even if prices dip further — because the rates right now are very low.

But suppose rates go up over the next two years, sale prices fall further, and a few years down the road you need to move?

Yet again, stability is the most important criterion in determining who should buy and who should rent. If there is a high likelihood that you will keep the same job, spouse, and children for the next decade-plus, then buying makes perfect sense. If you are unmarried, or have a job that might move you to a different location, then renting is much less risky.

Posted by TFF | Report as abusive
 

“That’s 1.15% of the value of your mortgage every year for 30 years — all going directly to insurance premiums, which are a crucial part of the financial-services profit machine.”

Just for clarification, you would only owe mortgage insurance for the time where you have less than around 20-22% equity in your own. It is doubtful that this would be the entire 30 years.

Posted by donhalljobs | Report as abusive
 

Felix, your logic is sound, despite a few minor errors, such as the one pointed out above on insurance. But for heavens sakes, you’d think the poor woman had recommended people dump their savings into universal life insurance, variable annuities and gold bullion. Yes, there are good reasons not to buy a house, and yes, Americans remain a bit too enamored of housing. But really, being forced to put money into a piggy bank that you can live in isn’t that awful.

Posted by JackO4 | Report as abusive
 

Stability is the #1 issue with buynig a house. Do you want to live in that place for a bare minimum of 5 years and at least possibly for the next 10 years. If you can’t answer that with some level of confidence then probably best to rent.

… unless you buy a 3 bedroom 1.5 bath with a detached garage like one of my friends did for $87,000… at an auction. Ya the place was trashed and will probably cost another 10k to make it liviable and another 10k after that to make it decent… but any way you slice it it’s a 200k house for 107k and some elbow grease.

The other reason to buy now rather than later might be the interest rate. If you’ve got steller credit and you can get 6.15% (5% fixed for 30 years plus the insurance.) In 5 years rates could easily be 8%. You’d come out way ahead to buy today in that world.

My bet is for average price to be flat for the next year or two… but rates to rise sharply.

Posted by y2kurtus | Report as abusive
 

I answered here there, but I find it odd, after advocating that you use the money to invest rather then a down payment, she now says this…

“And if you banked your cash instead of tying it up in your house, doesn’t that give you more leeway to pay your bills while you sort out your finances?”

Posted by hsvkitty | Report as abusive
 

Also, Felix, the insurance premium is going to the FHA, a government agency that insures the loans. No bankers or brokers get rich off that.

Posted by right | Report as abusive
 

If they still offer non-recourse loans, isn’t Linda right? I wish I were judgment proof.

Posted by maynardGkeynes | Report as abusive
 

There’s ONE way in which her advice is good: suppose you’re a young adult with good income but no wealth.

Buy one of those no-money-down homes leveraged 10:1 (that’s 10% down, folks). Make those modest monthly payments for the next 30 years.

And if it doesn’t work out so well? Your employer evaporates or you shred your legs while snowboarding and go to can’t-afford-the mortgage disability checks? Never mind, just declare personal bankruptcy, even if you’re in a state where you lose the house. You haven’t built up much equity to lose. Maybe you even find some government program to get your loan rewritten, or cover your payments.

Not only do you get a good deal on the house, you also learn how the investment banks work!

Posted by WaltFrench | Report as abusive
 

It is crazy how Linda (and some commenter) think that walking away, recasting your mortgage or declaring bankruptcy are a panacea. I’m fortunate to not have faced severe personal financial pressures, despite a 15 month stretch without employment in the most recent downturn (I was able to lower my rent twice during that time, once through negotiation and once through relocation). However, an acquittance who hasn’t been so lucky paints a picture of financial distress is not what Linda makes it out to be.

Calls from creditors, the bankruptcy process and dismantling your lifestyle because you live paycheck to paycheck and lost your job are all emotionally distressing things. They should be because a mortgage will be the biggest promise that most people will ever make in their life short of marriage or the commitment to raise children. If Linda thinks that having low equity but assets on the side will help in the modification process, I wonder what mods she is looking at.

I can sleep perfectly well at night renting and knowing that I may miss out on some home price appreciation, but haven’t promised hundreds of thousands of dollars of payments over the next several decades.

Alternatively, she made no case that since mortgage rates are low, if they do eventually rise, who will buy the houses? If rates go up, housing becomes less affordable so pricing (in real terms) should go down. I always thought that the best strategy was to buy houses when rates were extremely high (think around 1980) and refi as rates fall. After all you can always renegotiate your financing but you can’t renegotiate the purchase price. Of course inflation has a large effect on this argument, but she doesn’t address this (I think that a lot of the “own housing for the long term” crowd are influenced by housing’s performance though the 1970s inflation).

Posted by TurtleBay | Report as abusive
 

TurtleBay, I’m a strong proponent of “own housing for the long term”, but I see it as a core element to demonetizing my life. If you earn and spend money, the government grabs 40% to 50% of the money in the process. If you set up your lifestyle so that it does NOT require cash flow, then your income needs are much less.

Imagine two couples in retirement. One owns their home, free and clear of mortgage, has a vegetable garden that meets their needs for 5-6 months out of the year, lives within walking distance to half their activities… The other rents, spends, and drives. Which couple needs to generate more income in retirement? Which couple will end up paying higher taxes?

Owning your home is one of the biggest risk-management decisions you can make. You ensure a steady supply of your most expensive basic need at a low cost (once the mortgage is paid off).

Posted by TFF | Report as abusive
 

Is she suggesting rather than pay down debt you “invest” spare cash? I can only assume in her “calculations” she didn’t bother taking into account tax.

In the UK any income she is going to get from an investment is going to be taxed at at least 18% – the CGT rate – so to get 4.87% after tax she needs a fund that is consistently returning about 5.9% year in year out with zero risk in this environment.

The only two reasons, off the top of my head, to not to do so are:

1) Liquidity – which means no mutual fund and just banking it in a current account.
2) Most capital repayment mortgages front-load the interest payments so all you are doing is paying interest early. In this case it doesn’t make sense to pay down with excess cash until maybe 1/3 of the way through the mortgage.

PS haven’t lived in the UK for a while so the tax rates may have moved but the principle should remain.

Posted by Danny_Black | Report as abusive
 

I think TurtleBay is mostly right. I realized quickly that home sellers think of their home in terms of total purchase price, while home buyers look at finances through the lens of monthly payment. In markets with raising interest rates sellers resist lowering price to offset the additional interest component of the monthly mortgage payment — but eventually, market equilibrium achieves some kind of adjustment. Thus, his advice to buy when rates are high actually makes a fair amount of logic, and only in retrospect do I now realize that’s what I did (with absolutely no foresight on my part). I financed originally at 10.5 percent, which went to 8.5, 7 and then 5.25 percent (all 30 year except the last, which is 15 year).

Likewise, if all mortgages were standard 15-20 year, prices would go down in many markets because monthly payments would go up.

I tend to think that the way home ownership benefits people is that at the end of the mortgage period people have mostly unthinkingly put away money in an asset, like a piggy bank, and it’s there for them. They could do the same thing with the money they save from not having to pay interest or maintenance, and wind up in the same place, but they don’t.

I would also say that, notwithstanding interest, the housing market can’t be rigged the way other asset classes can. Basically, if it goes up it goes up pretty much across the board in a regional kind of way — whereas very clearly, stocks and bonds can be and often are manipulated to the advantage of specfic investment classes.

Posted by rb6 | Report as abusive
 

@TFF & rb6

Owning your home is one of the biggest risk-management decisions you can make. You ensure a steady supply of your most expensive basic need at a low cost (once the mortgage is paid off).”

“I tend to think that the way home ownership benefits people is that at the end of the mortgage period people have mostly unthinkingly put away money in an asset, like a piggy bank, and it’s there for them. They could do the same thing with the money they save from not having to pay interest or maintenance, and wind up in the same place, but they don’t.”

These are two very perceptive comments. The Shiller analysis of home prices over more than a century basically says that houses go up with inflation over very long periods of time with variation up and down that can last for 2-3 decades along the way.

My housing goals are simple:

1. Own a home that is worth less than 20% of my total portfolio at retirement.

2. Have the mortgage paid off before retirement.

3. Don’t use the house for income during the active years of retirement.

4. Regard the house as a form of long-term care insurance. If you need to move out into some form of assisted living, it should be able to pay for much of it.

This means that you effectively have to “live below your means” from a housing standpoint so that you can make your other savings from the disposable income that your realtor and bank want you to spend on your house instead.

Posted by ErnieD | Report as abusive
 

Good comments, ErnieD, though I would rephrase it slightly. My retirement goals:

(1) Own a home, mortgage paid off before retirement. (Hopefully by the time I am 50, since I want some flexibility in case I end up involuntarily unemployed five years before I planned to retire.)

(2) Use the house to live in, not for income, considered apart from my financial assets.

(3) Have a retirement portfolio sufficient to provide for cash needs with additional reserve for emergencies or long-term care.

I don’t think it is relevant whether the house is more or less than 20% of your total net worth, as long as your investment portfolio (does NOT include the house) is sufficient for your cash needs.

Posted by TFF | Report as abusive
 

@TFF

The 20% is for our personal situation living in our area with our housing costs, our income, and our saving plan. It would vary by family. I agree that it should not be a “one size fits all” target, although I suspect that the ratio would be an eye opener for many people who bet big on housing a few years ago.

Posted by ErnieD | Report as abusive
 

@ErnieD, perhaps people err by counting their house in their net worth?

If the value of your house has increased, then your implied cost of housing has increased (it represents greater capital tied up). Net effect on your standard of life is zero UNLESS you sell the house — and you probably don’t want to do that right away.

My wife convinced me several years back that the financial assets are more relevant, since it is those that will produce the income to support retirement needs. So now I only add the value of the house in when I want to impress myself with a big number.

Posted by TFF | Report as abusive
 

Speaking of which…

I count the mortgage as part of my net worth calculation. I don’t count the house. This may seem odd at first glance, but it gives me a more meaningful number than either alternative — it targets financial resources and obligations.

Posted by TFF | Report as abusive
 

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