Paul Ferraresi

Most people think that the worst of the housing crisis has passed. They should be preparing for a flood of home inventory that will overwhelm the markets and cause prices to fall even further.

For the past 3-4 months there has been a form of moratorium on foreclosures set up by the present administration. Most institutions with delinquent mortgages have not foreclosed and your tax money has been used to cover the bank losses during this period (dumb move). There are only a few foreclosure signs in the neighborhoods, but, the rest of the banks are rushing to get their properties onto the market.

From December 2008 until March 2009 the number of bank asset managers inquiring about foreclosures dropped by 80%. Recently, the number of inquiries has skyrocketed as they see the inventory coming to market. Expect a flood of new properties in June.

Many investors entered the market too early and are now unable to “flip” the properties. They will now have these same homes foreclosed on them.

All of the administration’s efforts to revive the housing markets have failed. Those who are losing their jobs cannot buy homes, interest rates are rising, crowding out buyers and prices are continuing to fall.

Rental properties now have negative cash flows and will also come onto the market. In addition, builders are being supported in states like California. The state is providing a $10,000 credit to buyers of new houses bought directly from builders on top of the $8,000 Federal Credit. This encourages builders to build more houses that are not needed. It is estimated that more than 500,000 new homes will be built this year.

Lastly, many second homes were bought from the equity in people’s primary residence. Many of these homeowners need cash so they are selling the vacation homes which adds more inventory.

So with the end to the foreclosure moratorium and unemployment increasing it shows that more foreclosures are on the way. Keep you powder dry as there will be GREAT opportunities for you to make “buys” as prices continue to erode.

I hear from people that with the current mortgage crises in place it is very tough to refinance their homes. These individuals are distraught as many want to obtain a better interest rate or pay off their mortgage at a faster pace. Following the principles of Doug Andrew’s bestselling book Missed Fortune, I think one should keep the early payoff in perspective. Ric Edleman, who extols the same principles as Doug Andrew, has written many books and articles on the subject. One of them is…10 Great Reasons to Cary a Big, Long Mortgage.

Here are Ric’s top ten reasons for keeping a mortgage along with my thoughts. There is a link at the end of the article so you can read the whole article. I welcome your questions at any time.

Reason #1: Your mortgage doesn’t affect your home’s value.

True, your home value goes up or down whether or not you have a mortgage. Your home does not know it has a mortgage. Go ahead…stand in front of your home and ask your home if it has a mortgage or not.

Reason #2: You’re going to build equity anyway.

True, equity is built in two ways
• Through increases in the value of your home
• Through principal paid monthly. (which is very small in the opening years) Any cash put into your home earns a zero (0) rate of return. Stay with the home values increases to build your equity.

Reason #3: A mortgage is cheap money.

Also true, as long as interest rates are low. When inflation is high this leads to higher interest rate. Thus, your future mortgage payments in an inflated environment mean you are paying back in cheaper dollars. Thus, rates are cheap in most situations on a relative basis.

Reason #4: Mortgage interest is tax-deductible.

True again, as long as you can itemize deductions. If your income is too high, then these deductions are not available. To circumvent this, you can run the mortgage interest expense through your side business LLC, so it is deductable.

Reason #5: Mortgage interest is tax-favorable.

This is tied into #4 but holds true in that our government looks favorably on a mortgage deduction in order for that most people to participate in home ownership.

Reason #6: Mortgage payments get easier over time.

If you have held a mortgage for a long time then this is understandable. In the opening years of paying a mortgage most people are strapped with the payments. As years go by a person’s income goes up while the mortgage payment is a constant. Thus, as a percentage of the higher income the mortgage is a smaller percentage.

Reason #7: Mortgages let you sell without selling.

As your equity increases in your home do not sell the home to get out the equity. Instead refinance, take out the equity, invest those monies rather than leaving them in the home earning a zero (0) return.

Reason #8: Large mortgages let you invest more money more quickly.

The strategy is to place a small down payment and invest the remainder since any cash in the house earns zero return.
Reason #9: Long-term mortgages let you create more wealth.

Consider the after tax cost of your mortgage and invest the difference in a higher tax free return investment.

Reason #10: Mortgages give you greater liquidity and greater flexibility.

A 30 year mortgage gives you more flexibility than a 15 year mortgage. You can always pay off a 30 year mortgage earlier, but, you cannot stretch a 15 year mortgage into a 30 year plan.

See the whole article: http://www.ricedelman.com/cs/education/article?articleId=232

Assess the Ultimate Goal

Usually when you ask clients whether they plan to buy a second home for pleasure or investment, the response is “pleasure.” The follow-up questions should then be: “How long do you anticipate owning it?’ Then, “What, if any, growth rate do you expect on the value of the home?” Very rarely are there “rational” responses like “20-plus years” and a “5% or so return” (which is the approximate national residential 20-year average rate of return for a home).

Many buyers anticipate that the value of their second home will double, even though they say it is not an investment.

Often clients will buy on emotional and perhaps irrational factors. They will also base their decisions on some misguided information or misinterpreted facts. The following are some of the more common misconceptions:

A vacation home is a vacation home. A vacation home can be categorized in three different ways: personal, rental, and dual purpose. The one that pertains to your individual circumstance will depend on the days used and the days rented.

I always can deduct my mortgage interest on my second home. With so many affluent clients purchasing McMansions these days, it is not uncommon to see a large mortgage on their primary residence. Remember that you can generally deduct qualified residence interest on up to $1.1 million of home mortgage debt ($1 million worth of acquisition debt on up to two homes plus $100,000 of home equity debt on up to two homes). Any excess interest on home mortgage debt is generally nondeductible. Furthermore, the owner’s overall interest deduction may be lessened due to the itemized deduction phase-out rule for higher-income taxpayers (for 2007 the AGI level is $156,400). This rule is expected to sunset by 2010. As such, if nothing is done, in 2011 it will revert back to full phaseout. (Now there are legal methods that we use with our clients that allow them to deduct interest on well above the $1.1 mm limit).

I always have to report rental income. Rental income is completely tax-free for property that meets the rules for personal-use property, but has a very limited opportunity to generate rental income (generally 14 days or less). From a tax perspective, this can be quite a boon for clients with properties that can be rented at an exorbitant rate for a short time (e.g., properties located near a major golf event, Olympics, or Super Bowl location).

Vacation home donations are always a good idea. Unfortunately, the IRS considers vacation home donation days as personal use days, not rental days, since the owner did not receive a fair market rental for the use if the home. In addition to not qualifying for additional rentals expenses, the owner receives no charitable deduction for donating the use of the home to charity.

I can use the capital-gains tax exclusion ($500,000) upon sale. The exclusion applies only to principal residences.

A 1031 (tax-deferred) exchange can be done on a vacation home. A recent Tax Court ruling (Moore, T.C. Memo 2007-134) disallowed tax-deferred treatment for a personal vacation home. The court held that a couple’s exchange of vacation homes did not qualify for like kind exchange treatment because the homes were not held for investment purposes (as required by § 1031(a)).

Rental income will be offset by cost. With property prices still high, some clients may believe they will offset the cost of a second home by renting it. Unfortunately, clients forget that in order to cover their costs they often will have to rent it out at peak season, coincidently the weeks they want to use it the most.

This is a “business.” Many people say they manage their property and thus “materially participate.” In other words, they are in the business of renting real estate and are able to take losses against other taxable income.

You can go home again. And, finally, do not “impulse buy” while enjoying a vacation. If you have an interest in purchasing real estate at a great place where you vacationed last month, I suggest that you hold off until you have “felt out the neighborhood” for a while, meaning you should visit the location a few more times. You should focus on the commute to work, the community, people, activities, and amenities, and, very important, talk to as many locals as possible, particularly those who have owned vacation homes there for some time. Do you have a similar feeling of happiness each time you visit the location? Are your experiences consistent over time?

The financial ramifications as well as the emotional toll of purchasing vacation homes can be complicated. But understanding these rules and your expectations will open the door to some great discussions with your advisors.

The subprime mortgage market is in chaos, home prices are dropping, many mortgage companies have shut down and some banks are teetering at the edge of bankruptcy. No, the sky is not falling.

These cyclical actions in the world economy have happened many times before. For most people the 1930’s depression, bank failures and a 30% unemployment rate (after the depression) is something you read about. Yet, you have lived through your own chaos with the dot.com (actually dot bomb) meltdown and the tech wreck bubbles of the late 1990’s. Real estate and stock markets go through classic meltdowns every 25 years.

Those that have foresight, strong stomachs and are contrarians make their wealth by buying near the bottom (Hmmm… seems I heard that before… buy low, sell high).

The Missed Fortune Principles of Wealth Building have been written about many times in this blog. I suggest you review these articles found in the Missed Fortune subheading.

Are the ideas of building your wealth by properly using equity management still valid? Can you still profit by “being your own banker”? Answer… yes, yes and yes again. Who better to learn about banking than the Federal Reserve. I encourage you to read this short excerpt of “The Feds” recent white paper abstract report.
Federal Reserve Abstract Report, Dated March 2007:

Many households face the trade-off between paying an extra dollar off the remaining mortgage on their house and saving that extra dollar in tax-deferred accounts (TDAs) used for retirement. We show that, under certain conditions, it becomes a tax arbitrage to reduce mortgage prepayments and to increase TDA contributions because of the tax- deductibility of mortgage interest and tax-exemption of qualified retirement savings. Using data from the Survey of Consumer Finances, we document that a significant number of households that are accelerating their mortgage payments instead of saving in a TDA forgo a profitable tax arbitrage opportunity. Finally, we show empirically that this inefficient behavior is unlikely to be driven by liquidity or other financial constraints. Rather, the observed behavior can be attributed to a certain extent to the reluctance of many households to participate in financial markets as either lenders or borrowers.

So what am I saying? … Stick with the Discipline of professional investing, or, suffer the Regret later in life.

I continue to teach my clients that equity in a home has a zero rate of return. So, why would anyone try to pay off a mortgage quickly?

Simply put…how much interest does your bank pay you on the down payment on your home? (zero, correct). What is the largest down payment anyone could make on an home purchase (100%, or pay cash for it) Therefore, all the money tied up in your home gets a zero rate of return, it is not liquid and it is not safe. Read the rest of this entry »