Liquidity! It Affects Everyone, Not Just Big Banks

Image from https://www.treasuryandrisk.com/

You might have heard about the markets having “liquidity” problems, but to the average Joe, this could sound like technical mumbo jumbo.  I mean, how does liquidity in the markets affect you?  Believe it or not, it can massively affect you.  Besides inciting panic in the stock market, which probably has affected your investments since late February, lack of liquidity means there is less cash out there to lend.  For a few weeks, this made it difficult for people already in a home purchase contract to close on the deal without paying a premium interest rate for their new mortgage. 

Most conforming loans are made by a mortgage lender who fully intends to sell your loan on the secondary market, typically to a real estate investment trust (REIT) that takes capital from investors, ranging from ordinary people to big funds owned by the likes of Vanguard or Fidelity.  The REITs also take out loans from big banks to buy more loans.  Then, when people pay their mortgages, the cash from those payments flows through the REITs to pay off principle and the interest is distributed to shareholders as dividends.  The principle in reinvested into new mortgages, and the cycle of life continues.  The main investor draw to REITs is their high dividend yields.

In March, something crazy happened related to the Coronavirus crisis.  Some of those big banks called the loans made to the REITs.  Why?  The banks were worried and wanted to get some cash to act as a safety net in case cash flows from operations waned significantly.  The REITs didn’t envision being so unstable that the banks would ever call the loans due.  At the same time, stocks like AGNC and MITT dropped by as much as 80%.  MITT could not come up with enough cash to pay back the called loans, and many feared default.  Lucky for the REITS, their knight in shining armor, A.K.A, the Fed rode in on their shining horses and bought up some of the REITs’ holdings at a discount, potentially staving off a wave of bankruptcies.  This also shored up the mortgage market for future loans.  This situation is a case-in-point on how delicate the economy is.  Liquidity is everything. 

Without the government providing free capital to all of these REITs and banks, mortgage rates would go much higher.  This was the case for many years.  I remember in the 2000s, a 5.50% interest rate was fantastic.  A good rate in the mid-1990s was 9%.   I also remember earning 4-5% on my ING savings account.  I would be elated for rates on my savings like that now.  I keep chasing a 1.40-1.70% yield on savings and the banks keep dumping the rates because they can get cash for less from the Fed.  Banks make their money on the margins of what they pay out in interest and what they charge on loans and credit cards.  When you deposit your money in a bank, the bank keeps a mandated reserve and can loan the rest.  If they fall below this threshold at the end of each business day, they take an “overnight loan” from the Fed at the low, low rate that you hear about in the news constantly.

Liquidity makes the capitalist market ebb and flow.  Many may talk badly about day traders or big fund managers, but the cash coming into the markets is what keeps prices real.  If they were not there, trading every day, you would never be able to sell investments out of your 401(k) and retire.  Everyday traders keep things going, even though some view Wall Street as criminal, the reality is most are out there working hard so that those who put money into the markets get a healthy return over the long term and can make their dreams come true.  The alternative is Social Security, which we know isn’t enough on its own for most to live a comfortable life in retirement.

So, all hail liquidity!  It’s essential for a smooth-running economy and stability for you and me.  To work, it needs a good balance of those who want to lend or invest and those who want to borrow and pay back the principle and interest, as scheduled. 

Check out my other blog posts and follow me on Twitter!  Thanks for checking out today’s read.

Disclaimer:  William owns AGNC and has recently traded MITT.  He also owns shares of SRET, an ETF that holds a range of REITs.  This article is not intended as investment advice.  Please consult a licensed investment broker for complete investing advice that aligns to your risk tolerance.

Credit Scores: Playing the game

If you’ve been following my posts, you probably realize I’m not very excited about debt.  Like most things I’ve ever wanted in life, a great credit score is something that I wanted for years and today don’t care to use very often.  I used to be all about getting the best interest rates, but today it’s about saving as much as I can to build wealth and realize my next big dream of owning a house I designed, on a good sized lot, away from people.  Well, far enough away that my Great Danes barking near the house won’t both my neighbors. 

Image from wsj.com

I learned a long time ago, building credit is a like a game.  It’s you against your creditors.  If you minimize your balances and carry almost no credit card debt, don’t open new accounts often and always pay on time, you will build a great score after several years with minimal interest paid, and you win.  If you’re impatient, run up your cards near or over their limits, and pay late, you’ll suffer financially and you lose on interest and fees and your score is lower. My advice is to never open a card account if you don’t have self-control.  I do admit having self-control with credit and the self-control to stick to a budget is pretty much the same thing. 

Throughout the years, I have found it much easier to spend on credit.  Every automobile I have purchased was on credit, although through each car acquisition, I had more down and a priority to pay off the load as fast as possible.  Now that I have enough saved to go out and buy a car with cash, I wouldn’t dream of parting with my hard-earned cash.  I’ll continue to enjoy my paid-for truck for years to come. 

What makes up your credit score?

Generally, there are five attributes that are counted in your credit score (listed in order of importance):

  • Payment history:  Do you pay on time? (35%)
  • Amounts owed:  How much of your credit lines are utilized? (30%)
  • Length of credit history:  How old is your oldest account and the average age accounts? (15%)
  • New credit:  How many new accounts do you have and can you manage them? Inquires? (10%)
  • Types of credit used:  What is the mix of cards, installment loans, and mortgages? (10%)

For more detail on what makes up the average credit score, check out this old CNBC post as it is still relevant today!

Each attribute is weighted more than the other because paying on time is more important than your credit mix, but it all adds up.  This is why you can build a decent score in as little as two years, but it will take seven or more, and take multiple loan types, to show you really know how to handle your debt load.

To have the best scores, you should rarely apply for new credit.  Once you find a great credit card, if you use one, stick with it.  Don’t try to open up new cards in search of better rewards.  Also, if you do open a new credit card, do not close the old one unless it has an annual fee.  Try to keep the card active by charging something every few months and paying it off before interest accrues.  I have a lot of good card accounts that I have obtained over the last 20 years, and keep open just because of age and the high limits help me ensure that even if I have a balance of $5,000 or so one month, my utilization is only around 2-3% of my total credit lines.  Always keep your purchases well below your limits.  If you keep getting close to the limit but pay it off before interest is due, apply for a credit line increase to help keep your score high.  Remember the credit is like having money.  The more you have, the less you need, and the more attractive you are as a borrower (until you borrow too much!).

As far as credit mix, having auto loans, student loans, and mortgages will all help your score.  Mortgages are considered “good debt”, which is debt that shows you are really responsible and making sound financial choices.  Also, it usually means you have equity and assets, which means if you don’t pay your creditors, they can try and put a claim towards your assets and gives them a little more assurance you will pay them back.  Most people who own homes are responsible and want to keep their home, therefore why credit card companies love homeowners.  If you have not assets, besides retirement assets, you are judgment proof and if you default, creditors will have no asset to try and claim, so all they get to do is put a bad mark on your credit and make it impossible for you to borrow until you clean up the mess or it ages off your report in a decade.

Earlier, I mentioned that I don’t strive to have the best credit cards or brag about my credit score.  As I’ve learned through the years, showing how much you can borrow through flaunting lavish houses and flashy cars is not the best use of credit.  Instead, build credit to get the best mortgage rate and know that insurance companies look at credit scores when setting auto premiums.  When you do borrow, do it strategically.  For instance, I really am tempted to pay down my mortgage, but my interest rate is so low, that I feel good having a beefy emergency fund and plunking a large amount of my paycheck into retirement.  Based on historical, long-term returns, I will come out ahead having my cash compounding at 8-12%, rather than at 3%, which is what I get while I pay off my mortgage. 

I do agree with Dave Ramsey that you can pay your house off quickly and then shove boat loads of cash into investments afterward, and probably come out about the same, and there is more risk involved with holding a mortgage, but I do insure against potential chaos with a large emergency fund. If I had kids depending on me, I might change my strategy, but being single, I feel pretty good about my risk levels. 

How do you feel about the use of credit scores in consumer lending?  Is it a fair practice?  Do you think that creditors should look at other factors besides a score? Leave me a comment! I’d love to hear from you.

Should I Refinance? Completing a Break-even Analysis

Last week, in my post Lessons Learned:  Financing My First Home, I wrote about buying my first home and the financing process behind obtaining it.  I mentioned briefly that you should do a break-even analysis anytime you are thinking of refinancing.  This could be a mortgage loan refinance, or something else like student loans or an auto loan.  What’s the best way to go about figuring out if the refinance is viable and the best choice?

As an accountant, I like to do this in a spreadsheet.  I have added the Excel file shown within this post to my new Templates page, where I intend to share my tools that you can use to become savvier. 

There are different scenarios to look at when doing a break-even analysis.  First, in a refinance, you shouldn’t consider “sunk costs” or money you have already spent on interest.  That’s because you have spent it and will not save anything in the future.  Let’s imagine you were thinking about refinancing from a 30 to a 15 year mortgage with the objective of paying less interest and owning your home free and clear, sooner.  Imagine the interest rate you have on your 30 year is 3.625% and the new rate would be 3.125% on a 15 year.  Also, let’s say you are three years (36 months) into paying your 30 year mortgage, so all the interest you have paid at the higher rate is a sunk cost.  According to my spreadsheet, you have paid interest of $27,804 (note: for this exercise, I am rounding to the nearest dollar).  This point is important because you will want to start at your current ending balance for the refinance, or $247,625.

Loan amortization schedule snapshots by W. Vance

Next, copy the tab and use your current ending balance for the refinance, or $247,625, as the loan amount.  If your loan officer tells you there is no “out-of-pocket” costs, you will need to add in the closing costs from your good faith estimate.  Let’s assume the costs to refinance come to $3,500.  This will need to be added in as your loan balance will increase, for a new loan balance of $251,125.  Change the interest rate to 3.125% and the term to 15 years.

Loan amortization schedule snapshots by W. Vance

You can already see you would save BIG by making this move if you take the total interest of the 30 year loan, less interest already paid, less interest that would be paid on the 15 year, less closing costs ($142,486-$27,804-$43,170-$3,500=$68,012).  This savings is if you assume you stay in the home for the next 15 years and would have paid the minimums on the 30 year mortgage. 

So, where is the break-even in all this? 

This part is where the Excel spreadsheet makes it easy to spot about when you will hit that magical point in time where you are profitable in your refinance.  To do this, I went back to the original, 30 year tab and added columns for the cumulative interest from the refi-point (December 01, 2017 in this case) and linked the cell for cumulative interest from the 15 year tab.  Then, I added in a difference tab (30 year cumulative interest, minus 15 year cumulative interest), and followed the total down until it was close to $3,500 in closing costs.  In this case, in month 31, or two years and seven months into the schedule, I would break-even on my refinance.

Loan amortization schedule snapshots by W. Vance

So, this seems like a lot of numbers and does it really matter?  I mean, a lower rate is always better, right? 

Not always!  Let’s say you started paying your 30 year like a 15 year.  Then your break-even would be much further down the road.  In this case, by not refinancing, you save the $3,500, but pay your old, slightly higher rate.  This means it takes even longer to break-even, which is at month 41, or about three and a half years.

Loan amortization schedule snapshots by W. Vance

Let’s imagine that I wanted to move to a new home and sell this one within the next three years.  Then it would be a bad move to refinance, because I wouldn’t recoup my closing costs with interest savings.  Doing nothing is better in this scenario.

Other Considerations besides savings and break-even points

Sometimes saving on interest looks good on paper, but may be more difficult to execute in real-life.  If you have seen a good increase in income since purchasing your home, and other goals are complete or well underway, then refinancing to save interest over the years may be a great move.  However, if you still need to build up emergency cash, kid’s college savings, or have consumer debt, you should hold steady and divert extra cash to those goals.  Also be careful that a higher mortgage payment doesn’t drive you into debt in other areas such as using credit cards to make up for the cash being spent on the house.  This defeats the whole purpose of a refinance and likely has you paying more interest because of the credit cards.  Only refinance if it saves you a considerable amount of interest and beware the temptation to fall for those ads to refinance and take cash out or lower your payment by resetting the amortization clock on your loan.  If you have 20 years left, and find rates have dropped, make sure you request a 20 year term and not a 30.  No one wants to be paying for their home long after their retirement, or worse yet, can’t retire because they took out a 30 year mortgage at age 55! 

Did I completely overwhelm you with all these calculations?  Don’t feel discouraged!  I’m an accountant and sometimes get carried away.  Send me a comment on your situation and I’m willing to help!

Lessons Learned: Financing My First Home

From Fortune.com via Getty Images

I can’t believe it has been 13 years since I started the process of buying my first, and current home.  I was intimidated.  I didn’t know a lot about the process and I was mostly scared of rejection.  For a long time, I didn’t think I would ever qualify.  My then significant other and I would drive around, looking at homes with for sale signs in the yard and talk about what we like or didn’t like, but we would always be taken back by the prices. 

Then, in April 2007, I found a new home development in the suburbs that seemed like it was in our price range.  We went and looked on a Saturday afternoon and liked what we saw.  The sales person happened to have attended high school with my significant other, which helped make us feel at ease.  In hindsight, we probably should have sought the help of a realtor, but we were naive and only in our mid-twenties. 

We went back the next day, Easter Sunday, and decided to take the big leap and go into contract.  I wanted to be a homeowner so bad.  I rationalized everything, and took the only lot available with the floorplan we could afford.  In hindsight, I wish we would have waited for a bigger lot.  The next week, we went to the affiliate mortgage company and applied for financing.  In order to keep the house under contract, it was required we get approved for financing.  An important part of getting a mortgage is to have a property picked out.  Without it, you can only get pre-approved, which is a good way to see how much home you qualify for, but is not that same thing.

We didn’t know much about the types of mortgages available, so we went with what the loan officer said was the best for us.  In hindsight, a 7/1 adjustable rate mortgage was not the best pick.  Payments were interest only for seven years, with an adjustable rate, then reset at regular payments for the remaining 23 years.  Five percent of the home price would be our down payment and 15% would be from a home equity line of credit (HELOC).  Prior to the 2008 financial meltdown, people could avoid private mortgage insurance (PMI) by financing this way, because the first mortgage was only 80% of the value. 

I believe these types of loan packages are a thing of the past (thankfully!).  I recommend a 15 or 30 year, fixed rate mortgage, with no points, unless someone else is paying those for you.  Points are prepaid interest that lets you buy down the rate so your payment is lower over the life of the loan.  Always do a break-even analysis with any type of refinance and see how long it will take to recoup the savings versus the higher rate.  If you are not planning on staying in your home longer than the breakeven point, then don’t spend the extra money and refinance or pay points.  To understand more about the different types of mortgage programs, visit this Bankrate page.

Once approved, we didn’t have a locked interest rate because our home was not slated to be completed for over four months.  Eventually, in June, we were able to lock our rate and know better what our monthly payment looked like.  At the same time, we were saving for our down payment, which back in 2007, was allowed to be stated, and not verified, as long as you had that amount by the time you closed.  Of course we made it and bought the house, rode the value down and in 2012 was able to refinance to a fixed-rate, 30 year loan, at 1/3 less interest.  This was made possible by the HARP program, which allowed people to refinance underwater mortgages that were at a higher rate or part of a sub-prime loan such as the one we were sold.

The lesson I learned is to always do your homework by understanding the different options available.  If you don’t qualify for a financing option you want, make sure you understand the reason.  If you feel uncomfortable with a mortgage officer, or company, then step away and call some other companies.  Also, remember that you are the customer and they want to sell you a loan because if not, they don’t get paid.  If you don’t qualify, or don’t feel good about the deal, chances are you will regret it.  Speak up and be your own advocate, and if you have an elder family member or friend who has been through the experience, don’t be afraid to ask them to sit with you, or at least look over the deal.  You can buy your first home, but make sure it is planned out well, or your home might own you and limit your life outside of making your monthly payment.

Do you have any home financing nightmares to share?  Leave a comment!