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THE COLOR PURPLE - AND I DON'T MEAN THE MOVIE - PART II
One of the important components that distinguish a Pick-A-Payment from its cousin, the Pay Option ARM is the combination of a 125% LTV (loan-to-value) combined with a 10-year recast. To understand why a longer recast term is essential we need to look at historical home market cycles.
When we recognize that borrowers are frequently given to exercising the minimum payment exclusively, if we don't allow enough LTV and a long enough time horizon to allow the property to cycle completely though a down market and back into an up market, the borrower (and bank) run the risk of depleting all the equity. However, when we allow enough time for the property to recover through a down market cycle and appreciate we provide both the borrower and the bank with equity. Let's look at the example that follows that is based on real COSI numbers and uses a margin of 2.30 which is reflective of the margin at the point in time for this scenario:
At the top left box we see a loan at $340,000 on a purchase value of $427,500 at 80% LTV. We know there may be years where no appreciation occurs on the property or that the property depreciates as well as years where the property appreciates at unusually high rates, as we've seen here in California. (The national average is 6.65%, but we are taking a conservative approach in this example.) However, since our spreadsheet does not have the ability to fluctuate these assumptions we have chosen to take a very modest 4% assumption year-over-year appreciation, which is below the national average.
The loan inception date is January 1, 1997 and is based on actual COSI returns shown in the top right box beginning at 4.98% with a margin of 2.30% for a beginning rate of 7.28%.
In the second left hand box we see our 4 beginning payment options, which will change as the rate changes, or in the case of the minimum payment, which is based on 1.95%, will increase as shown in the second right hand box in 7.5% increments at the beginning of each New Year.
In the next section we show the approximate average difference between the Interest-only and the 9 year-over-year minimum payment so that if we wanted to invest this amount we could do so. For purposes of this scenario we have chosen not to do so. However, in situations where there is a tremendous difference and the borrower has the capacity to invest the difference and create a compounding arbitrage situation (i.e. putting it into a matching 401k contribution, etc.) the numbers can be very compelling.
In the Annual Investment & Equity Position section towards the bottom this is where we can see the three important elements we mentioned above come into play: 10-year recast term, 125% LTV recast and last, but certainly not least, the stability of the low-volatility COSI Index.
In this scenario we have assumed that the borrower exclusively elects to make only the minimum payment, and thus will likely incur negative amortization. The rates are reflective of actual COSI fully indexed rates from 1997 through 2006.
If we look at year 5 what we note is that despite negative amortization, the Original LTV Ratio is still well below the 125% recast. Our mortgage balance has grown from $340,000 to $382,598, or neg am of $46,478. However, despite our negative amortization and because of our average 4% appreciation our home has appreciated by $137,522 which is $50,022 above original equity position of $87,500. In the middle of year 9 (July to be exact) our payment will reset to our 30-year fully amortized payment as our minimum payment will have reached the level of our 30-year payment. At this point our home will have appreciated to $632,000 and our mortgage balance will have grown to $473,321, or neg am of $133,321. However once again, despite our negative amortization and because of our average appreciation our home has appreciated by $145,527 which is $58,027 above our original equity position of $87,500.
In the remaining section of our spreadsheet we detail the cash flow we received from making the minimum payments versus the fully-indexed 30-year payments and/or versus the interest-only payments. We can also see at what point we run out of cash flow versus the other options.
Before we talk about the cash flow, let's summarize what just happened and also address another aspect of these types of products that is perceived to be a negative, the pre-payment penalty. In this product the client has the option of increasing his rate by 10 basis points and reducing the 3-year pre-payment penalty to a 1-year pre-payment penalty. The Study by Professors at Columbia and NYU which was highlighted in the Business Week article on September 21, 2007, entitled, "Surprise: ‘Toxic' Mortgages Are Best" made the following determination about pre-payment penalties:
"The optimal contracts do not allow borrowers to refinance their mortgages with another lender. Offering this option would increase the borrower's reservation value, which would limit the ability to provide him incentives to repay his debt, resulting in a decrease of efficiency of the contract. Therefore, our results lend support to prepayment penalties on refinancing. Introduction of borrowers' mobility would result in a "soft" prepayment penalty, borrowers could sell their homes at anytime without penalty, but if they want to refinance the mortgage, they would pay the prepayment penalty sufficiently large to discourage it."
Interestingly enough and little known to ‘outsiders' who sell this product, once the borrower has been in this product for at least one year Wachovia will WAIVE their pre-payment penalty if the borrower elects to stay in a Wachovia "portfolio product". Similarly, if the borrower sells their home and within 6 months purchases another home and employs a Wachovia "portfolio product", Wachovia will reimburse the borrower for the pre-payment penalty incurred by the sale. Seems they were ahead of the Study curve.
Naturally, it is the objective of the bank to make money and because this product is not sold into the secondary markets, but is held in the banks' own portfolio, thus the name, pre-payment penalties help facilitate this. However, it is also helpful to the borrower, according to the Study, to stay the course over the long term so that the borrower can reap the benefit of a full market cycle.
This leads us back to our first chart about housing market cycles and how they play into the 10-year versus the 5-year recast. If our borrower is in a much more volatile index, such as the Libor, an increasing rate environment, and is deferring interest every month, not only are we likely to hit the LTV limit faster (even before a 5-year term) but if our housing market is in a declining mode, such as we have been experiencing, this is a recipe for disaster. It does not allow the borrower enough time to recoup or build equity. Add to this the fact that many of these similar products dip down to as low as a 1% minimum start rate (Wachovia is currently set at 1.95%) and you have a potential for some devastating negative amortization when improperly used.
Looking at the cash flow portion of this spreadsheet, we probably don't need to waste a lot of space or your time by highlighting the imprudent uses of this money (i.e. flashing some new sparkler on ones finger or racing down the road in our mid-life crisis). What might be a prudent, if not lucrative use of this cash flow?
Paying off higher interest debt (how about your ELOC or credit card debt?)
Building a retirement fund
Investing in a second home or investment property
Creating an investment portfolio
By the way, for all the negative press that pay option ARMS get, isn't it interesting that no one is beating up Equity Lines of Credit (ELOCs) which also deplete borrower's equity and generally do so at higher interest rates? Not to mention the fact that if the borrower has a cash flow issue in any given month they are out of luck as their payment is generally fixed at an interest-only or fixed payment, which when added to their primary mortgage can become unmanageable in a climbing interest rate environment or a cash flow crisis.
So how might a borrower use the cash flow that is generated when exclusively making a minimum payment? Let's examine two real-life scenarios from my client data-base as well as some other suggestions.
Mr. & Mrs. Smith are 60-year old teachers. He is an amputee. They are sitting on about $300,000 of equity and are looking to refinance their existing mortgage (rate and term). They plan to retire at 68. In completing their 1003 and asking questions I am able to determine that Mrs. Smith has a PERS that will provide her with $300 a month upon retirement and Mr. Smith has no retirement (he works part-time at religious college). The borrowers don't intend to sell their home upon retirement as a source of income; in fact they've installed an elevator in the home for the benefit of Mr. Smith in anticipation of his declining mobility. With this in mind I structure a cash-out Pick-A-Payment loan with as much cash out as the borrower can comfortably handle with the minimum payment. I align them with one of my trusted financial planner advisors who place the assets into various age-appropriate investments. We then take the difference between their amortized 30-year payment and their minimum payment (the cash flow) and we introduce that cash flow into the new investment on a monthly basis. At the end of 8 years when the Smiths are ready to retire, they will now have a minimum of $1,800 a month in additional retirement assets that would not have had before. We're using the cash flow to constantly extract the equity in the home that is not earning interest and put it to work compounding interest to help ensure their future retirement. Naturally, this strategy could have been even greater by having more years of arbitrage and compounding, but we have definitely improved the future quality of their financial health and wealth.
Mr. Jones is a 38-year old professional who enjoys a comfortable lifestyle. He lives in one of the nicer neighborhoods in a fairly upscale home which has appreciated quite well. However, he is equity rich and cash poor and has run up a fair amount of credit card debt and has come to inquire about a cash out refinance to consolidate some of these debts. He wants a fixed rate. In reviewing his situation I discover that he has not participated in his company's 401k where they offer a 100% match! Not only is he missing out on building his retirement and the tax benefits of doing so, he is also missing out on doubling his money tax free. In questioning him, he doesn't feel that he can afford to make the money contribution as his monthly life-style taps his monthly income pretty heavily. We set him up in the COSI Pick-A-Payment, and similar to Scenario 1, he takes the difference between the interest-only and the minimum payment and invests this amount into his 401k monthly. By doing so his monthly income is taxed at a lower rate and he picks up the 100% match of his company's funds.
What are other ways to put this cash flow to work in ways to increase your client's financial health and wealth?
Because of the power of arbitrage and/or compounding, what if your borrower took the difference between the minimum payment and interest-only or 30-year payment and invested it and at the end of the ten year option put the money back into the loan or another investment property?
What about using the cash flow option in lieu of a more expensive reverse mortgage which is also accompanied by age restrictions?
What about borrowers who have gotten "behind the eight-ball" in higher interest rate credit card or ELOC debt?
We routinely hand borrowers their equity through cash our refinances and ELOCS where often this money is not used to further their financial health or wealth. Lenders have notoriously written ELOCS behind pay option ARMS that have, unrestrained, tapped out the remaining equity in the borrower's homes. Yet many have reduced the mortgage market meltdown to the responsibility of pay option ARMS at large, with no distinction between the characteristics between these products. Likewise, many have dismissed or overlooked a borrower's responsibility to their own financial prudence.
There are good products and bad products. There are prudent borrowers and imprudent borrowers. There are borrowers & lenders who take responsibility for becoming educated about the choices they make and recommend and those who do not.
Like many tools that can be used for good or bad, hopefully I've provided you with some new information that can help you distinguish between the characteristics of these types of products that can help you and your/borrowers enjoy the tremendous benefits associated with cash flow options while ensuring that you've maximized as many borrower protections as possible.
The facts and figures don't lie. This product has been in the market place for 20 years. In California where tens of thousands of foreclosures are happening within these types of products, this product has less than 200 REOs YTD. Borrower protections and portfolio underwriting have built a product that has created 20 years of ongoing borrower success.
I follow up with my clients personally, at least semi-annually, with respect to how much they've deferred, and I re-review the parameters of the loan to help refresh in their memories the characteristics of the product and I readdress any questions or concerns they may have. I do this for the first 3 years of their loan. It not only helps cement the concepts in their minds it certainly doesn't hurt our relationship either.
Yes, there will be borrowers that should be led far from this type of product. Personally I use credit reports and what I garner from my conversations as a good barometer as to each clients' level of responsibility and future goals regarding financial health. Some borrowers are simply committed to a life time of financial suicide and I don't help them commit it. Others have committed to change or become more astute. I believe we still need to exercise our own prudence as professionals and make sure the product fits the client, their situation and what we determine to be their future financial goals.
Not all Pay-Option ARMS are alike. And if I may add, some are not ‘toxic'. It pays to not lump every product into one category but to judge each book by it's individual content.
Disclaimer: ActiveRain Corp. does not necessarily endorse the real estate agents, loan officers and brokers listed on this site. These real estate profiles, blogs and blog entries are provided here as a courtesy to our visitors to help them make an informed decision when buying or selling a house. ActiveRain Corp. takes no responsibility for the content in these profiles, that are written by the members of this community.