The Priority System of Money

 I have had the privilege and opportunity of working with numerous First Time Home Byers (FTHB) and I have always enjoyed the experience. There is generally a little more education required - that's a big part of the reason I enjoy it. Beyond the necessary home and mortgage questions, I spend a fair amount of time talking about money and general finances with my FTHB clients. I do not give specific investment advice as I am not a licensed financial planner, but I am more than equipped to introduce general strategies (I have a finance and marketing degree from Cedarville University). Once these strategies have been introduced, I happily refer my clients to a financial planner to help them continue developing the plan as well as assist with implementation.

Regardless of a client's income or background, there is a general road map that will help ensure financial success for those that follow it. It is a plan I have adopted and adapted from other mortgage and financial professionals and has proved to be extremely flexible to a client's unique situation. Obviously this is a general plan and my recommendations will vary depending on your situation. If you would like a customized mortgage solution, please don't hesitate to contact me (tim@timothyabbott.com). There are four general principles and we'll take a look at each one.

1. Establish an Emergency Fund - The first thing I recommend to clients is to get in the habit of relying on yourself rather than a credit card to get you out of a financial jam. These things come at every single one of us whether we like it or not - a new water heater, tires on the car, etc. Everyone should have a minimum of three months worth of income in a completely liquid fund (savings account) that you could access today if you needed it. If you are self-employed, paid largely by commission or bonus, or have an irregular income source you may want to have as much as six months worth of income set aside. This is strictly rainy-day money and is there to keep you out of the jaws of the 18%+ credit card monster.

2. No Debt Other than Mortgage - Once a client has put away their rainy day fund, the next step is to eliminate all non-preferred debt. This debt will be anything other than your tax-deductible mortgage. Typically credit cards should be paid off first, then auto loans, and lastly student loans. Often I'm asked whether this should be the first step instead of the second. These two steps could certainly be switched but the concern is usually a discipline issue. Some people are quite capable of paying off their bills and then committing to the savings plan. Other people freely admit that it will be a challenge. This is when we would recommend saving first (to develop the habit) and then focusing on paying down the debt. I want to help set my clients up for success and generally speaking we have a better chance if we start by saving the emergency fund first.

3. Build a Source of Liquidity - This fund will again be different for every person but it is typically equivalent to six to twelve months worth of your income. This is an ultra-critical part of the plan as these funds will allow us to deal with both good and bad opportunities. A bad opportunity is unfortunately all too easy to describe. Things such as job loss, extended leave from work (for your illness or a family member), disability, and natural disasters are all things that people face. I don't know about you, but I would much rather be prepared and have access in the event my wife or one of my daughters became ill and I needed to take some time off from work to help out. Without this fund a person would need to make some difficult choices.

Good opportunities can be more difficult to quantify. These opportunities can appear in the form of having the ability to start your own business, invest in a business with a friend or relative (that probably sounds more like a nightmare for most people!), buy a second home or investment property, or anything else that comes along. These are opportunities you would not even have a choice to make if you didn't have the funds available. Opportunity cost can be a very painful thing if you haven't experienced it before.

4. No Mortgage on Your Balance Sheet - Please notice I didn't say NO MORTGAGE. The goal is to have an asset account (401K, Roth IRA, taxable stock portfolio, etc) that equals or exceeds your mortgage balance. Once you have completed the first three steps, the additional money you have been putting away and/or paying towards debt can now be allocated towards this goal. This is generally the method that provides the greatest amount of safety, liquidity, and rate of return while giving you incredible flexibility and allowing you to have the capability of paying your mortgage off early. I will give you an example in a later post that shows the incredible power of leverage and arbitrage you command with your mortgage.

There is certainly no one size fits all approach, but this is a very good set of guidelines that will help a majority of people accomplish their financial dreams and goals. If you have any comments, constructive criticism, or general feedback, I would love to hear it!

The $3.6 Million Mortgage

There are few things as interesting as the mortgage market (to me, anyway). It has been a fascinating study and exercise to follow the demise of the subprime mortgage market. There have been volumes written about it here, here, and here. I am not going to take the time to rehash the discussion especially since the folks I just mentioned have done such a great job. One interesting observation I've noted more and more frequently is the complete swing of the pendulum into additional lending areas that don't quite make sense to me.

The predominant theme in 2004-2006 was to extend more and more credit to people who were less and less willing and able to repay. Well, that ship hit the mother of all icebergs (and we all know what happens then). The market is still flush with liquidity and investors don't like those funds just sitting around, so they need to find an alternative to lend money. What is the complete opposite of people with poor credit and no assets? How about wealthy people with plenty of assets.

The New York Times has a great article (here, registration req'd) documenting this phenomenon. In a nutshell, there are more and more companies blowing the roof off of traditional lending standards when it comes to multi-million dollar homes and mortgages. Let's take a look at Seth Weinstein:

"SETH WEINSTEIN is not a guy who likes to run a tab. He has only two credit cards - one for his personal use and one for business - and he says he pays them in full each month. He even wrote a check the last time he bought a car, a white Volvo convertible.

But Mr. Weinstein, who for nearly the last 30 years has developed office buildings and condominiums in the New York area, and who seems to be allergic to the idea of accumulating debt, was approved for a $3.6 million mortgage last month for the $4 million condominium he is buying at the Century at 25 Central Park West.

The loan is a two-year floating-rate mortgage that will carry payments of roughly $24,000 a month at what he estimates will be an interest rate of 8 percent through the term of the loan. He plans to refinance in two years after making some renovations on the apartment.

Mr. Weinstein chose the condominium over a similar co-op apartment, where the limit on his mortgage would have been $2 million. He said he wanted to use as little of his own money as possible to buy the apartment, preferring to invest it in Connecticut real estate, where he expects the returns to be 25 percent.

"It's not the case that I'm cavalier about debt," Mr. Weinstein said. "I can make a much better return on that in my business."

It's worth noting that this article is largely anecdotal evidence and centers around New York City. Also, the gentleman referenced above is a real estate developer, but many of the people seeking these types of mortgages are investment bankers, hedge fund executives, and Gordon Gekko wannabes. For the most part these folks have been able to do no wrong in the last few years. My question is this - when the markets experience the inevitable correction, what will happen to their compensation? What will happen to their assets? I would like to think that they are all well diversified, but I don't know.

I thought this was worth mentioning because this is one of the very few instances I've found where underwriting guidelines have been loosened rather than tightened. I will continue to monitor the market and will let you know of any interesting/substantial changes that occur.

Thanks for reading and have a great holiday week!

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