Teach Your Children Well

If there is one hopeful financial plan described by Baby Boomers these days, it is the uniform, unanimous thinking out loud about owning a home free and clear someday.

Everybody makes sure there is no penalty for early repayment (there hasn’t been a penalty on any Federal agency loan since 1983), most inquire about 15-year loans, and many want us to run some amortization math: “If I send in an extra thirty-two dollars a year, how much sooner will my loan be paid off?”

There is a certain allure to the thought of no house payment, but not enough to explain the blind allocation of resources to mortgage repayment.

Alternatives fill a spectrum all the way from blowing the cash in favor of a higher immediate standard of living to saving the money instead of sending it in to the lender. Saving the money is not only better finance for several investment and tax reasons, but also safer than free and clear ownership. Disbelievers, read on.

The free and clear instinct had a sound financial basis 60 years ago, but modern finance long since made the drive obsolete. I believe the rigid, free and clear reflex persists because it has been taught generation unto generation, but the reason for the teaching long gone and forgotten.

The parents of the average Baby Boomer were young teenagers during the heart of the Great Depression. Their parents, the Boomers’ grandparents, were trying to hold on to houses and farms at the time, and losing more often than keeping.

Prior to 1935, borrowers were wise to fear their mortgages, and their bankers. Then, mortgages were short term, one to three year rolling, renewable “balloon” notes. Long term loans were unknown. “Renewable” meant you had to go back to the banker and reapply.

If in the time since the original loan was made your financial condition had deteriorated, or the value of your home had fallen, the banker would refuse to renew, and take your keys in lieu of payment.

Mortgage lending on these terms was one of the main things that made the Great Depression great. As more people lost jobs, and could not re-qualify, more loans were called. As more properties were seized and liquidated, values fell, and more loans were called — even those made to people who still had jobs and could make payments. Banks obeyed their orders in a regulation-driven suicide pact, and loans cascaded into foreclosure.

This snowballing disaster caused the grandparent of the Baby Boomer to tell the parent, who told the Boomer: “Mortgages are dangerous. Own that house free and clear!”

However, this thinking became obsolete before the Depression was over. One of FDR’s most important “alphabet agencies” was the FHA, which introduced the first 30-year, fixed rate mortgages in a successful effort to stop the waves of foreclosures and bank failures.

If you get a thirty-year loan, nobody can foreclose on you just because the value of the house falls during a tough couple of years. Nor will you have to re-qualify every year or three. If you lose your job, and have enough savings to make the payments until you get a new job, it hurts, but nobody can take the house. You can play defense by renting out rooms (as one of my grandmothers did to survive the 1930’s), or putting that lazy husband to work.

If something goes wrong in your financial life, and you don’t have savings, then you are in trouble.

Let’s say you have diligently prepaid your mortgage for ten years, and fifty percent of the home’s value is equity. You have some savings, but they are locked up in a “can’t touch” retirement account.

Then your employer goes on a restructuring binge, and you and your salary are structured out. No banker will loan you a dime against your carefully hoarded equity. (Did you know that your “equity line of credit” is annually cancelable if your income falls apart?) Maybe you could sell a car to buy yourself another few months’ time before foreclosure.

In the modern era, one of the few goodig adjustment at the end. Bythen you will probably have refinanced anyway. The high caps allow the lender to make up for a big mistake inthe first five years; in return, the lender gives you a cheaper first five than tight caps would allow.

Trade away the periodic cap for a low life cap. You can still find ARMs with a life cap in the elevens if you’llshoot craps from year to year.

It is very desirable and very expensive to buy down the margin. Margin is a big deal because it’s a fixed cost ineach adjustment. Breakeven for buydown tends to be three and a half years — when it’s allowed.

Keep your intentions clear about how long you will own the house, how long it may be until the next refinancingwindow, and what the Fed is up to. Don’t ever be tempted into an ARM at a bottom in rates, or frightened awayat the best time- at a high in rates, or rising into one.