Last week, I was in Starbucks talking about interest rates and the current real estate market. It was not unusual that I was in Starbucks nor conducting business there, as it seems that Starbucks, these days, maybe second to the golf course in the culmination of business. This day, I happened to be talking with Ken Cusick. Ken and I were discussing the vulnerability of those homeowners who purchased their home with adjustable mortgages, primarily interest only mortgages and their mortgage rates. Ken had a lot to say about this topic. Ken is the principal of Cusick Financial, LLC, a financial consulting firm located in Olney, MD specializing in residential and commercial financing.
Ken and I agreed that many homeowners have a great mortgage rate because of the historically low interest rates we have had recently. I expressed my concern about the many homeowners who have bought their home with an interest only or variable rate mortgage to either allow them to buy more home than they normally could afford, or to keep payments down. After all, the interest rates for these mortgages usually started between three to four percent. This cut the mortgage payment by at least a few hundred dollars a month, if not more.
Ken had a few things to say in response, as well as a few words of advice. First, Ken asserted that because the interest only and variable rate mortgages are tied to short term indices, they usually tend to be a better deal than 30-year mortgages (which are tied to long term bonds and indices). Depending on the type of index the mortgage is tied to, the interest rate can change annually or even as frequently as monthly. He stated that the unusually low interest rate environment we have had in the past five years has made housing more affordable, which paradoxically led to the significant increase in home prices we have experienced.
Second, Ken stated that those homeowners who have a fixed rate mortgage would always be able to afford their home as long as their income never decreases and they never need to sell their home. Even if there is a correction in the real estate market to lower home prices, these homeowners are in good shape.
Third, homeowners who have interest only or variable rate mortgages are subject to the volatility of the market as rates rise and fall, and are at significant risk. As interest rates rise, their monthly mortgage payments rise. Additionally, as interest rates rise, the cost of housing rises and housing demand decreases. This creates difficulty for those who were betting on interest rates to stay low because the affordability of the mortgage becomes an increasing burden on those who may not be able to afford higher payments. Add that to the possibility of their home being devalued increases the burden of loss.
Ken’s advice was simple. If the homeowner could not afford the mortgage payment with an increase of of interest by two to three percentage points, then they should refinance into a fixed rate mortgage. He admits the payment will be higher, but the comfort that the payment will not change should be peace of mind in an uncertain future.
If, however, the mortgage rate does not adjust in three to five years and the homeowner intends to sell in within that time period, Ken says to hang in there. The logic is that the only risk the homeowner takes is the possibility of the home depreciating in value. If the mortgage balance is 70% to 80% of the current home value, then the risk is much less.
To many, Ken’s advice would seem a bit too conservative. I, however, believe that this advice to be the consensus of good financial planning.
by Dan Krell © 2005
This column is not intended to provide nor should it be relied upon for legal and financial advice.