LOS ANGELES It's clear that leverage was one of the main culprits of the financial meltdown, but what other factors were at play? For advisors, allowing clients to take too much leverage on mortgages was irresponsible and immoral, according to financial planners at the Milken Institute's conference in Los Angeles.
WHAT ADVISORS DID WRONG
Advisors allowed many clients to use their houses as ATMs, looking at housing as an ever appreciating asset, says Josh Rosner, an analyst at Graham Fisher & Co. and a speaker on a housing panel at the conference. "Housing should not be looked at as an investment. It should be treated as a forced saving plan and a utility," he says.
Another panelist James Lockhart, vice chairman of WL Ross & Co. notes that the financial crisis was caused largely by people who got carried away with an up market cycle. Too many people, of all income levels, refinanced and took out a second mortgage, he said. Instead of saving that money though and allowing it to compound, investors spent it. "Investors didn't know what they owned and their legal rights. And advisors didn't properly educate them, he says. And since the crisis, we have done nothing to really fix the plumbing.
So what has the financial crisis taught advisors when it comes to handling mortgages for their clients? And what can they do to fix the plumbing?
Here are some of the most common mistakes advisors say their clients make with their mortgages and the implications of those mistakes.
1. LISTENING TO THE WRONG PEOPLE
According to Michael Fein, managing partner at CIC Wealth, people often end up making their financial decisions by listening to the people they play golf with or their family. But those people are generally not in the same socioeconomic status and age group, he says. "Instead, common sense needs to dictate."
Some clients are also listening to advisors with conflicted interests, Fein adds. Simply put, Fein notes that many advisors (on mostly the wirehouse and bank side) would prefer for money to not be put into a mortgage and instead be put into a pool they can manage for the purpose of collecting higher fees based on AUM. In terms of the client's best interest, though, clients should pay off their mortgage as quickly as possible, Fein recommends.
"I deal with certainties. We know there's a mortgage, interest and taxes," he says. "I truly believe we should deal with the known. The known is debt, and dealing with that can achieve peace of mind."
2. CHOOSING THE WRONG MORTGAGE
Advisors helping clients choose the correct loan must consider how long they will carry the loan, the steepness of their income curve, expectations of future interest rates and many other factors before choosing the type of loan to finance their home purchase, Lawrence Verzani, a recent graduate of Texas Tech University's personal financial planning doctoral program, says. For example, households that are likely to move in the near-term would be much better suited to an adjustable-rate mortgage rather than a fixed-rate mortgage in order to take advantage of the lower rates available on adjustable rate mortgages, according to Verzani.
Next, it's important for advisors to consider a household that reasonably expects to stay in the property for a long period of time, does not expect their income to exceed the rate of inflation and does not hold much in appreciable assets, according to Verzani. This household might be inclined to use an adjustable rate mortgage in order to make their initial payments more affordable, however they would risk defaulting on the loan should future interest rates increase.
3. PAY OFF THE MORTGAGE OR NOT?
At the height of the real estate bubble about eight years ago, people were often motivated to take money out of real estate investments and put it into the market, says Ron Rhoades, a professor at Alfred State College's financial planning program. Advisors who are paid by AUM fee or commission don't have a financial incentive to encourage clients to pay down a mortgage rather than investing.
But in the wake of the financial crisis, which left so many homeowners underwater, advisors should be stressing the importance of
4. REFINANCING TOO SOON
Savings from refinancing home mortgages can be substantial, advisors explain. For example a $200,000 mortgage with 20 years left saves approximately $30,000 in interest over the life of the loan if refinanced to 4.9% from 6%.
Before a mortgage refinance can be considered, however, it has to overcome the cost of refinancing. The value of the option to refinance and future interest rates must also be considered as well as the probability of paying of the loan early, according to Verzani. Refinancing too early or too late can cost households tens of thousands of dollars, he explains.
5. REFINANCING TOO LATE
Refinancing too late can cost households just as much as refinancing too early. If rates reverse, households can lose their refinance opportunity. Whether or not a client chooses to refinance, advisors note that it's essential for clients to base the decision on how long it will take to recapture the fees associated with refinancing.
6. NOT CONSIDERING A REVERSE MORTGAGE
Longevity risk is a serious concern for retirees and a reverse mortgage is a great tool to address that risk, advisors point out. A popular option for reverse mortgages is the reverse mortgage line of credit. A potential problem with the reverse mortgage line of credit is that, similar to removing equity from the home, it can be suggested by advisors as a way of increasing AUM fees or sales. A less popular option to use the reverse mortgage in order to receive a stream of income for life is better suited to managing longevity risk but does not address large unexpected costs as well as the reverse mortgage line of credit, Texas Tech's Verzani explains.
Advisors such as Fein point out that reverse mortgages only make sense for retirees who need extra income to retire and want to stay in their home for much longer.
Bottom line: Advisors note that it's imperative they make sure their clients don't buy a home (or homes) with more than they can afford, that they have an appropriate liquid cushion of cash in case of personal hardships like divorce or job loss and that they can make monthly payments of principal and interest over the life of the loan rather than extracting equity.
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