Monday, August 07, 2006

More On Buyer Psychology

More on our excursion into buyer psychology and in this particular case on buyer's unwillingness to "do the math":
What I would like to discuss is how such a transaction (the re-finance mortgage, and in particular the Adjustable Rate Re-fi) is pitched to the home owner. Just for the reader’s information, my expertise in this area is based upon the closing of over 750 of these transactions in the last 4 years, most of which involved Adjustable Rate Mortgages (ARM’s).

An ARM amortizes the principal and a fixed interest rate only for a period of years, normally two to five. After the initial term, the interest rate fluctuates with the prevailing rate at the time. The selling point of this loan type is a lower interest rate than a traditional 30 year fixed rate mortgage. In some instances, the payment can be several hundred dollars a month cheaper. Of course, the borrower is concerned the rates are trending higher and wonders if this is a good idea. The mortgage broker “solves” this issue as he explains to his client, “in six months, your credit will be better, and we can lock in a lower fixed rate at that time.”

The question then comes to mind, is it worth it?

Forecasting future interest rates is rather difficult. I do not think I will get much disagreement with that statement. Considering the current trend and historical averages, however, perhaps we can forecast slightly higher rates in the next two years. If this is the case, how can the borrower be sure his payment will go down once his credit score improves? Sure, his score might qualify him for a lower rate, but how much lower, the borrower is unsure. Could it be the rate for a 30 year fixed mortgage is higher in two years than the adjustable rate is on the date of closing? It is certainly possible, is it not? In my opinion, the borrower cannot possibly be sure if his future fixed rate will be lower in the future.

If the borrower actually re-finances his ARM in two years, he will have to pay these same closing costs [$8,845 for a $200,000 loan] over again. Virtually none of these can be avoided unless you have a friend who is a lender. The costs outweigh the dollar on dollar monthly payment savings by over 8 to 1. What a deal! Remember, this calculation does not even consider the time value of money or opportunity cost on interest paid.

Meanwhile, if you look again at the amortizations, you will see that virtually none of the principal is paid after two years. What this means is the borrower must start the process again, paying almost all interest for the first several years and virtually none of the principal. In effect, the borrower has been renting his house for two years – the bank as the landlord. After all, it is the American way.

Of course, a mortgage banker would probably resent this analysis and likely offer the following rebuttal: An honest banker (trying not to laugh) would make sure the product/loan fits the borrower’s needs. For example, a good loan officer would ask whether the borrower plans on staying in the home or if the borrower expects to move in a few years. If he stays put for 30 years, the savings and “peace of mind” more than outweigh the closing costs.

But this is an awfully big “if”. And since the borrower misplaced his crystal ball, he usually nods and says he has nowhere to go. But the “honest” banker knows the vast majority of people move within 5 years and virtually no one pays their mortgage off in full anymore.

The real problem is that people trust these bankers to get them a good “rate” which the borrower thinks is the heart of the issue. The real issue is the amount of the loan. The rate is simply the smoke screen bankers use to separate their customers from their money, time and time again. I see closing costs in excess of $10,000 in these deals over and over again. But the borrower almost never asks about them. All he is concerned with is the rate and payment. If the figure fits into his budget, he signs the papers. It is as simple as that. A simple look at what it costs clears away the fog – yet very few every bother to do so.

I guess they figure the price of real estate will always go up and that the costs are simply what you must pay to play in the real estate market. Essentially, a home owner takes a position in a free market asset just like a trader takes a position in the futures or equity markets. But real estate is usually a highly leveraged asset in an illiquid market. These two characteristics of the residential real estate market pose significant risks to owners of this asset class. Of course, maybe they are right. Perhaps this time it IS different.


Anonymous Anonymous said...

Very educational! So many friends have said to me over the last couple years, "oh, our mortgage broker was great" or "our loan officer made it really easy." The face of lending HAS changed: it used to be you had to give them everything short of a blood sample in order to get a first-time home mortgage. Now anyone, even with subpar credit or low income, can walk into a mortgage broker's office and just tell him a few things (they'll fill out the forms) and walk out with a huge amount of debt.

Aug 7, 2006, 5:56:00 PM  
Anonymous Anonymous said...

my expreience agrees with this,it is almost always "what's the monthly payment" and "how much can i get" any mention of risk is met with a blank stare.

Aug 8, 2006, 9:46:00 AM  

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