By Peter A. Rohr, PWA.
As a physician, your time is a priceless commodity. If you are considering a new home purchase, whether you’re seeking a new location, downsizing now that your children have left the nest or a second vacation/retirement home, there are several different financing options to consider. Hunting for a new home takes time, and once you find your perfect dream home, you are most likely ready to close the deal and move right in. To help you move into that dream home faster and with less hassle, it’s important to go into the process understanding your mortgage options, and having already spoken with your financial advisor about how a borrowing strategy fits into your total financial picture.
When considering a new real estate opportunity, remember to ask yourself how this purchase, whether it’s a primary residence, vacation home or strategic investment, fits in with your long-term financial goals.
· How long do you think you’ll live in or own this home?
· How much can you afford, given other financial goals and obligations?
· How might changing interest rates impact your situation?
· Are you comfortable with fluctuating mortgage payments and interest rates?
Answering these few questions can help you and your financial advisor decide what type of mortgage is right for you.
Traditional Lending Considerations
The traditional fixed-rate mortgage has been the standard loan used to finance a home purchase, but it may not always be the best alternative for financing a home purchase. As an established physician, you might be considering the purchase of a primary residence, vacation home, or even a condo for children in college as an alternative to campus housing.
While traditional loans are widely used and consist of part interest and part repayment of principal, transactions can take between 45 to 90 days to finalize because lenders take time to make sure their investment is not going to fail. Appraisals of the property are obtained, as well as a detailed investigation into the borrower’s credit history and financial status, which take time and money. Once the traditional loan is in effect, early payments pay off the interest of the loan, not the principal, so little is accomplished in increasing the homeowner’s equity. Take, for example, the first 10 years’ worth of payments on an amortized 30-year, $400,000 mortgage at a 6.25 percent fixed rate. The principal would only be affected by a $63,049 reduction.
In addition, once you sign on the dotted line, your mortgage rate is locked and will remain at that rate until your mortgage is settled by either refinancing, which can incur fees, or paying the balance of the loan.
A fixed-rate mortgage offers the certainty of regular monthly payments, but that typically comes at the price of a higher interest rate. According to Freddie Mac’s January 2005 Economic Outlook, inflation is expected to be contained, while long-term interest rates will rise moderately. The average 30-year fixed-rate mortgages will be approximately six percent in 2005 and 6.3 percent in 2006.
An alternative to the fixed-rate option is the adjustable-rate mortgage (ARM). ARMs generally offer a lower initial rate than traditional fixed-rate mortgages. And, some types of ARMs can be fixed for a period of time and then convert to adjustable. The interest rates on ARMs are often tied to a base rate index such as LIBOR (London Interbank Offered Rate) or the prime rate, plus a margin. The base rates fluctuate, which means your mortgage payment could fluctuate as well – increase with rising rates and decrease with falling rates, depending on market conditions. In other words, with this option you may run a higher risk of your interest rate increasing.
Still, the benefits are clear. To borrow at a fixed rate for 15 to 30 years, you have the predictability of a fixed payment each month. Depending on a number of variables such as how long you plan to keep the mortgage, your income stream, interest rate fluctuations, an ARM may offer you some benefits to help manage cash flow better. Many lenders also allow the option of prepaying toward principal without penalty on fixed-rate mortgages and ARMs to help contribute to equity and reduce overall interest expense.
In addition, there are innovative adjustable rate mortgages available today that combine the benefits of a fixed-rate and an adjustable-rate mortgage, also known as a blended rate mortgage. This blended rate helps diversify interest rate risk by combining a fixed-rate and an adjustable-rate during an initial period. Since the blended rate does not increase (or decrease) as much as a traditional ARM, this mortgage provides greater protection from fluctuating interest rates. So if rates go down, you’re not locked into a fixed rate and the monthly payments will go down; if rates go up, the impact on monthly payments could be less than a regular ARM.
When considering this option, homeowners should evaluate the length of time they plan to own their home and their overall financial goals. You may want to select the blended-rate period that matches or exceeds the length of time you plan to own the home.
Alternative Lending Considerations
As an alternative financing option, you might consider securities-based lending when closing on your home purchase. By choosing to use your securities as collateral instead of coming up with the traditional 20 percent cash down payment, this option will allow you to purchase your new home without losing ground with your current investment strategy. Further, your securities can still be traded with certain restrictions and can continue to grow without interruption.
For example, there are loan accounts available that enable you to pledge a broad range of eligible assets as collateral, such as your managed assets accounts, exchange funds or even third-party assets. Pledging assets as collateral is advantageous because you borrow against rather than sell your assets, enabling you to keep your investment strategy on track. Additionally, the credit you receive is based on the combined value of all your eligible assets in the account(s) pledged, offering greater borrowing power.
With your credit already established, there is no need for the lender to obtain an in-depth history of your finances. Therefore, the lender can activate the loan account within seven to 10 days, often completing the paperwork in as few as 48 hours, putting you into your dream home much faster and keeping your liquid assets in your wallet.
Finally, home-equity loans are another alternative for those who wish to finance more than the traditional 80 percent of the property value or fund a second home purchase. By securing a second line mortgage loan, you are borrowing against the equity in your home allowing you to avoid depleting cash reserves or selling assets, which could disrupt your investment strategy and could incur capital gains taxes.
Evaluate the Choices
When it comes to real estate, including a home, land, investment property or commercial real estate, whether your purchase is for you, your family or your business, making an investment in real estate shouldn’t disrupt your carefully-built financial strategy. To keep your money working for you while securing the home of your dreams, talk to your financial advisor about the benefits of various financing alternatives. A financial advisor can help you effectively manage your accounts and make the right financing decisions based on an evaluation of your entire portfolio, that is, both sides of your balance sheet. Taking these necessary steps will ensure you get into your dream home faster and more confident in your financing decision.
Peter A. Rohr, PWA, is a Senior Vice President – Investments and Private Wealth Advisor with Merrill Lynch’s Private Banking and Investment Group in Philadelphia.