Archive for the ‘Housing and Real Estate’ Category

Given the roller coaster ride that stock market investors have experienced and the negligible rates offered by banks on savings, it’s easy to see why someone might want to use their cash to pay off their mortgage.

Being debt free is not only noble but can provide a buffer in tough times since you’ll have one less cash outflow each month.

For every dollar you pay off in a mortgage, your rate of return is equal to the amount of interest that you’re saving. This is measured by the interest rate (net of the amount that is deductible of course).

So in this example, you could be “earning” 6.125% (less the deductibility of the mortgage interest based on your tax bracket).

Compared to other savings alternatives, that’s a great return. And compared to other equity investments it can seem a lot less volatile.

But before you drain the cash reserve, let’s look at this more closely.

  1. Tying up a lump sum of cash in a property can be risky. You may come up short on emergency reserves by using the bulk of it to pay off the loan.  Will you have enough cash to cover 12 months of your living expenses?  Will you have enough to cover operating expenses for the properties if they were vacant or you lose your job?
    • Considering that in this case you have three other investment properties and your primary residence, there is always the likelihood that you might need cash for an emergency repair or the cost of compliance with any changes in building codes or prepping a vacant unit for a new tenant or even to cover the carrying costs while a unit is vacant.
  2. Real estate is an illiquid investment. Once you send in the check to the bank you no longer have the cash readily available for use either to pay for ongoing expenses, cover emergencies or for other investment alternatives that may come along.
    • What if a really good deal on another investment property came along?  Depending on your market, you could find a very inexpensive property to buy that could more easily cash flow now but without the cash you’re out of luck. Sure, you’ll have more equity but to tap into it will require a bank to agree to give it to you which is more difficult on investment properties and your primary residence may not have enough equity to allow you to get a home equity line of credit (HELOC) or home equity loan to recoup the cash you may need.
  3. Property prices are still in flux.While savings bank rates are abysmal, losing money is even less appealing. By investing more in your property, you could actually see a negative return.  In some markets, real estate prices are still going down so it is conceivable that you could turn each $1 paid in principal into 90 cents.

What Are the Alternatives?

Consider a non-bank financial firm that is offering one of those ultra-high yield money markets for a good portion of this reserve fund.  It’s accessible and won’t cost you anything to hold and they tend to offer higher rates than most brick-and-mortar banks.

You could also split off a portion of the funds and find a ultra-short term bond mutual fund.  Average yields are about 2%.

For a small portion (starting at around $2,500) you could even use a convertible bond fund.  These are hybrid investments combining the fixed income of a bond with the potential capital appreciation of a stock.  These types of investments have held up well when interest rates rise because of Fed action or inflation.

For more information on these, you could check out my article posted on www.ezinearticles.com here.

Likewise, you could also consider other types of short-term bond investments like mutual funds that target floating rate notes.  These types of commercial loans are regularly reset and are a good way to hedge against inflation.  Since there is credit risk, you don’t want to put a whole lot of eggs in this one basket but 5% to 10% of your funds is prudent for you to consider.

As in all things, read the prospectus and speak with your adviser to determine if these are right for you in your situation.

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Much of the US economy is tied to real estate.  Buying and maintaining a home creates a very big ripple that impacts lots of industries and jobs.  Certainly, the bursting of the speculative bubble in building and lending has resulted in a devastating chain of events including an increase in home foreclosures.

In the economics textbooks I had to study back in college, the theory is referred to as “creative destruction” as industries change and assets are repositioned.  In reality, we’re dealing with individuals and families and it is a painful process.

In news accounts and on our own streets, we can see the impact as families who once were proud homeowners or even responsible tenants are forced to leave their homes as part of the foreclosure process.  And foreclosures continue to have a negative impact on real estate values.

Aside from the pain it is a necessary process to get to a floor in prices that will help lay a foundation for stable or future increasing prices.  And as the pendulum swings in the positive direction it will hopefully lead to a virtuous cycle for an improving economy.

Between here and there, between continued gloom and future hope, there’s some scary ground still to cover and put behind us.  Just like in the horror movie where the heroine is within sight of safety when the bad guy pops up again, we now have to look over our shoulder at some little noticed trends that threaten the nascent recovery.

Recently, the entire foreclosure process has been forced to grind to a halt in many communities because of the “robo-signing” of foreclosure notices by many of the nation’s largest banks and mortgage servicing companies.

But besides this well-reported issue there are other developments that are easily overlooked by those not involved in the industry.

  • No Title Insurance: Mortgages are secured by collateral.  In this case that means the land and buildings that sit on it.  Evidence of this comes in the form a deed that describes the location and the chain of title showing who owned it and what loans or liens have ever secured it. A loan cannot be closed without the lender being able to secure “title insurance” which protects the lender in the event that there is a claim by someone or some bank that says that the new bank’s borrower really doesn’t own it.  And right now title insurers are protecting themselves by avoiding issuing any insurance on any property that has a foreclosure in its history of ownership.
  • Uncertainty Leads to Gridlock: Nearly 20% of all real estate sales in August 2010 have been of distressed properties.  With the prospect of increased litigation and the drying up of lending sources, this will lead to fewer sales.
  • Legal Challenges to Evictions and Foreclosures Have and Will Increase: Such legal challenges will make it harder to clear the backlog of foreclosed inventory.  Costs to potential buyers and banks to defend claims will increase and make the idea of buying a “bargain” foreclosure property very expensive.
  • Banks Face Higher Unknown Costs That Threaten Their Survival: Aside from legal costs, the potential for fines and other penalties imposed by courts for the alleged fraud perpetrated by “robo-signings” means that banks will need to set aside more in reserve against this potential outcome and have less available to lend to consumers and businesses.
  • The System of Electronic Trading of Mortgages Is in Question: In the fast-paced world that we live in, we prize speed, convenience and efficiency. To help make the processing of lending and refinancing more efficient, the banking industry created the Mortgage Electronic Registry System (MERS) to allow banks to sell, package and transfer mortgages and mortgage servicing rights among them.  But one of the results of the “robo-signing” scandal is that courts may scrutinize MERS and rule that it really doesn’t own the underlying mortgages and has no right to transfer them.  If that happens, that will call into question who actually owns the loan.
    • Without clear ownership rights, then it calls into question who has a right to foreclose on a property.
    • If the lender is not really the lender, then homeowners can and have started ignoring the eviction and foreclosure attempts by these lenders.
    • If it is questionable about which bank owns the loan, then that devalues a big source of bank income from servicing the billions of dollars of mortgage, tax and insurance payments that it handles every month, a source of revenue to the bank and an important part of its valuation which will now also come into question.

However this plays out, it looks like the lawyers will be busy for a long time.  And the rest of us are left with a very big cloud over our head trying to recover from something way worse than any witch or pirate appearing at the front door this Halloween.

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