Minnesota Real Estate

Why is this topic important to you and your clients?
Real estate and mortgage planning should be a key component in the wealth management services offered to your clients. Your client's homestead and investment property are often some of the largest assets within their estate. Mortgages are almost always involved in a real estate portfolio. Many planners tend to focus on "investable" assets and overlook the real estate that may be the cornerstone of a person's wealth leading to poor or nonexistent recommendations in this area. Mortgage planning should be involved in the planning process beginning with the pre-acquisition period, continuing during the holding period and culminating with the ultimate disposition of either the primary residence or investment property. With proper recommendations by the financial planner/wealth manager will come a stronger client relationship. Ultimately, you will end up with a happier client, more investable assets and probably more billable hours.

There are other benefits too. Your clients need the expertise that you can provide in this area. Even if you prefer not to do the following analysis, you should at least understand the talking points and suggest or coordinate a meeting with the appropriate tax and legal counsel. This paper will explain common mortgage products within the marketplace today. In addition there are real world applications and examples which you can use in your practice immediately.

What are the problems I need to think about?
The following are just a few of the questions you might want to consider. I don't expect that you will have all of the answers. There also is no absolutely "right" answer to some of these questions. These are talking points that will probably involve other professionals on the financial management team. (1) Should a property be sold, gifted or refinanced to access the equity? (2) Is it better to die with a property in your client's estate in order to get a step up in basis? Remember that gifting property involves the recipient acquiring the original basis. Selling property instead of 1031 exchanging it can subject the client to taxes that could have been avoided. Refinancing gives the client access to capital on a tax deferred basis-while the interest may or may not be deductible. (3) What type of loan options are available for my client today? (4) Are there any creditor protections that would be better afforded my client by having greater leverage on their home?

Let's break down some of the basic considerations involving a primary residence. How long will the person own the home? How adverse to risk or change in payment will my client be over their projected holding time frame? The answers to these questions will give you the basis to begin exploring options. A common problem lies in mismatching the product to the holding period. Client goals can be maximized if you take the time to understand the products and then see how they fit into the client's financial plan. For example, if the client has a 100% certainty that they will move out of their home in 7 years, you may want to look at a product that matches exactly that time frame, or create a hedge of 2-3 years either side of 7 years in case things change. Under this example there would be no reason to recommend a 30 year fixed mortgage unless the pricing was identical or cheaper than one of the other available shorter term products.

What mortgage products exist in the marketplace today and what problems do they solve for my clients?

First mortgage products today consist of 5 primary products and variations thereof. Most first mortgage products assume a thirty year amortization. It is what can happen over those thirty years that varies. Let's make that assumption for this article. I will highlight 5 primary first mortgage products and mention one unique second mortgage option. All the options are available for your client's primary homestead. They all may not be available for a second home or investment property. The mortgage note rate is generally .5-1% higher when financing anything other than a primary homestead.

1) FIXED RATE AMORTIZING MORTGAGES Your payment with this type of loan is made up of principal and interest. Each is a component of the payment. The entire mortgage will be paid off at the end of the thirty years. Following the rule of 78, the loan will be paid off with the last and final payment. The most common variation of this type of loan is the 30yr fixed mortgage, but there are 10yr, 15yr, and 20yr loans too. The main idea here is that these loans are fairly simple. They are meant for the risk adverse with a very long term prospective of being in their home.

2) ADJUSTABLE RATE MORTGAGES(ARM) With these loans the monthly principal and interest payment is based upon a rate and amortization period that is fixed for a period of time within the overall 30 year time frame. It could be six months to ten years. The overall loan term is again 30 years. After the initial fixed interest period of time, the loan payments adjust up or down, subject to a formula. This formula uses a fixed constant called a margin. A typical margin on today's ARM's will have a number of 2.5-3.5. The margin is a fixed number and is arbitrary and established by the investor when the loan is originated. The margin is added to a variable which is called an index. The most common index is either the average of the yield on 1 year treasury bills or the 6 month Libor index. The value of the index will change over time. There are many other indexes and versions of the two I just mentioned. Most ARM's have "caps". Caps prevent the margin + index rate from exceeding a certain limit. These caps adjust on the adjustment date which happens upon the end of the fixed interest period. After the initial adjustment the loan payment will adjust according to the formula either annually or more frequently. It all depends on the product and how often the adjustment is made. For example, a five year ARM might have a fixed rate of 5% for the first 5 years. The loan is a 30 year loan. After the first five years the rate is subject to change. The loan has caps of 6/2/6. The first number, six, refers to the initial cap adjustment after the first five years. This means the rate upon initial adjustment can't exceed 11 % (calculated as the initial 5% rate plus the 6% capped rate). The next number, two, refers to the adjustment period every year after the first. A cap of two means the rate for every subsequent adjustment after the initial adjustment can't exceed two percent over the previous rate. Lastly, the third number, six, refers to the lifetime adjustment. This means that anytime the loan payment is adjusted, regardless of the math, you can't have a rate that exceeds six percent over the initial rate-which would be 11%. An ARM is best used to match a mortgage with a projected holding period. These can greatly enhance cash flow when looking at an investment property and should be considered as the preferred loan for short term holding periods.

3) HYBRID OPTION MORTGAGES These loans usually involve a combination of an interest only payment period of time after which the loan retains a fixed rate and amortizes itself over the remaining balance of 30 years. For example, a loan may allow an interest only payment period during the first 10 years of total 30 years. At the end of the first 10 years the remaining loan balance must be amortized fully over 20 years. The interest rate remains constant over the entire 30 years. These products are trying to combine the best features of both fixed and adjustable loans all rolled into one loan.

Within this category of loans there is a unique product called the Option ARM. It goes by other names too-Choice ARM, Pay Option ARM, etc. This type of loan generally allows repayment on a flexible basis that usually involves four repayment choices. Generally speaking, you can choose how you want to pay with the ability to change the payments each and every month. The mortgage payments can be interest only, negatively amortized based on a rate of 1-3%(depends on the loan and investor) with the deferred interest added to the back of the loan, 15 year amortization, or based on a 30 year amortization. The deferred interest (negative amortization) is the double edge sword of leverage. If the property is appreciating at a rate greater than the growth in the deferred interest the equity will exceed the amount of negative amortization. In the event that the market is flat or declining, the negatively amortized loan balance may exceed the value of the property. This is the "upside down" risk associated with one of these ARM's. This type of loan is often used by speculators in highly appreciating areas or on second homes where people want a low payment today and are banking on appreciation occurring in the future. The key benefit to this loan is the payment flexibility, which can be very important if your cash flow is erratic or you want to achieve the lowest repayment rate. Normally, the fully indexed rate (margin plus index) will probably be higher than the prevailing fixed rate mortgage or traditional ARM. This type of loan may also carry a prepayment penalty. As mentioned previously, an ARM is best used to match a mortgage with a projected holding period. Option ARMs can greatly enhance cash flow if you utilize the minimum payment option which will result in negative amortization. Utilization of the minimum payment (negative amortization) will allow you to control a more expensive property than could be controlled with any of the other payment options.

4) INTEREST ONLY MORTGAGES These loans allow for only the accrued interest to be paid-no principal payment is required. Prepayment of principal may or may not be allowed without a corresponding penalty. This will depend on the product and program. Mortgage payments may "recast" to reflect any extra payments that are cre