mortgage principal

Apache is functioning normally

I realized something important for all of you who have automatic mortgage payments and also like to automatically pay down extra principal each month. It is don’t forget to adjust your mortgage autopay amount when rates change.

When I refinanced a primary residence loan in 2019, I decided to get a 7/1 ARM at 2.625% with no fees. I had gotten a 5/1 ARM when I purchased the house in 2014 for 2.875% and I wanted to refinance before the rate reset.

Given I have an ARM, I always like to pay extra principal with each mortgage payment. So instead of making the regular $2,814.14 mortgage payment, I decided to pay $4,500 automatically each month.

$4,500 is a nice even number which pays $1,685.59 extra toward principal. This amount is on top of the $1,847 (goes up every month) that is already going to principal from the $2,814.14 mortgage payment. Not bad since the mortgage rate is so low.

Not only do I like taking out cheap debt to live a better lifestyle, I also like the feeling of paying down debt. Automatically paying down extra principal each month ensures I am making financial progress, even if I didn’t do anything else.

Over time, the extra forced savings from paying down more principal adds up! And when you’re finally done paying off your mortgage, you own a nice asset that can be rented out for cash flow.

Why Adjusting Your Automatic Mortgage Payment Is Important

Reviewing my mortgage payment history since 2019, I have consistently paid $4,500 since the beginning.

Most people just pay the mortgage amount each month, but not me. And maybe not those of you who like to accelerate your debt repayment as well.

However, since 2019, mortgage rates have surged higher thanks to the pandemic, government stimulus, supply chain issues, and the strong economy. Since 2021, I’ve also written posts such as:

In other words, even though I was recommending to not pay down extra toward a mortgage in a high mortgage rate, high interest rate, high inflation, and inverted yield curve environment, I was doing just that!

As someone who tries to act congruently with my beliefs, I was surprised to learn I had missed this financial move. As soon as I realized my inconsistency, I called the bank and had them lower my payment from $4,500 down to $2,814.14.

Paying down extra principal when the yield curve is inverted is suboptimal because you reduce liquidity in the face of a potential recession. If bad times return, you want as much cash flow and liquidity as possible to survive.

Paying down extra principal is also suboptimal when Treasury bond yields and inflation are high. You could earn a greater return risk-free and inflation is already paying down debt for you.

Why I Missed Lower My Mortgage Payment

With over 40 financial accounts to manage, it’s easy to miss things. I set up automatic payments for everything to eliminate missing payments. But the downside is that I sometimes fail to adjust my payments when conditions change.

The more complicated your net worth, the more you will miss things. There might be some big winner stock you’ve been holding for years that’s now in the gutter. It’s easy to lose track.

This is why tracking your net worth diligently using Empower or another free wealth management tool is important. Having at least a quarterly, if not monthly financial checkup, is important.

Benefits Of Autopay And Paying Down Extra Debt

Paying an extra $1,685.59 toward principal for 48 months ($80,908.32) isn’t the end of the world. I now have $80,908.32 less mortgage debt for this one property. I’ve accelerated the time to completely pay off the mortgage by several years.

However, from March 2022 until August 2023, I could have earned a guaranteed 4% – 5.5% return in Treasuries. This return compares favorably to the 2.625% return I made paying off the debt.

There is also another benefit to paying off a negative real estate rate mortgage. And that is saving money from a potential bear market. The extra mortgage principal payments I made in 2022 saved me from a ~20% loss plus the 2.625% in mortgage interest expense.

If I had never remembered to adjust my mortgage autopay, things would still be fine. I would simply have a lower principal balance in 2026, when my ARM resets.

I know only about 11% of mortgage holders have an ARM. However, if you get an ARM to save money, you might be more inclined to pay off your mortgage quicker. With a 30-year fixed mortgage, there is no sense of urgency to pay extra toward principal.

When To Resume Paying Down Extra Principal

It’s optimal to stop paying down extra principal automatically each month when rates are high and the yield curve is inverted. Therefore, the logical conclusion is to resume paying down extra principal when rates are low and the yield curve is upward sloping.

Specifically, I would resume paying down extra principal automatically when Treasury bond yields are equal to or less than your mortgage rate. The lower the 10-year Treasury bond yield is below your mortgage rate, the more you want to pay down extra principal.

Another time to start paying down extra principal automatically is when your cash flow and savings amount is strong, and you don’t know where to invest the extra cash. When in doubt, pay down debt.

We Will Earn, Save, And Invest More If We Want To

One final takeaway from this post is that most of us will rationally take action to improve our finances if we need to. Therefore, I wouldn’t worry too much about being permanently stuck financially.

I found this mortgage payment mismatch because I was motivated to find more ways to improve cash flow. We are in the process of buying another house. In addition, there is the potential for another recession.

As a result, I reviewed all our expenditures and realized this was the one expenditure that could free up a significant amount of cash flow ($20,227/year). I’ve also thought about going back to work to boost income and reduce healthcare expenses.

If I didn’t feel the need to boost our finances, I probably wouldn’t have connected the dots about this automatic mortgage overpayment. But I would if I found myself in a cash crunch.

If we need more money, we’ll find a way to save more, slash costs, and/or earn more. This logical behavior is a win for us all.

Reader Questions And Suggestions

Do you pay extra principal through your automatic mortgage payments? If so, how much more do you decide to pay? Have you remembered to lower your extra principal payments once risk-free rates surpassed your mortgage interest rate? Are you trying to improve cash flow due to another potential recession?

If you’re shopping around for a mortgage, check out Credible, a mortgage market place where you can find personalized prequalified rates. Credible has a handful of lenders on its platform competing for your business.

Listen and subscribe to The Financial Samurai podcast on Apple or Spotify. I interview experts in their respective fields and discuss some of the most interesting topics on this site. Please share, rate, and review!

Join 60,000+ others and sign up for the free Financial Samurai newsletter and posts via e-mail. Financial Samurai started in 2009 and is one of the largest independently-owned personal finance sites today.

Source: financialsamurai.com

Apache is functioning normally

Historically low mortgage rates had their moment in the sun in 2020. They rested far below 3% for months before America’s economic rebound pushed them back up in the winter of 2021. But data released on Thursday from Freddie Mac showed that mortgage rates idled below 3% again for an entire month, even with solid first-quarter GDP figures and encouraging consumer spending numbers.

Mortgage rates may look fickle, but the Treasury market rules them. If the 10-year yield rises it’s most likely the result of inflation expectations picking up, and with them, mortgage rates. When the 10-year-yield drops, inflation expectations are falling. That’s the simple answer.

While America continues to emerge from the COVID-19 crisis, other parts of the world are very much in the thick of it. A COVID-19 variant first identified in India has even threatened the U.K.’s plans to end lockdowns, Prime Minister Boris Johnson said.

Because the market is still so uneasy globally, U.S. investors relaxed momentum on the bond market, leaving mortgage rates with a better outlook than expected. Most industry experts predicted that rates would have settled far above 3% by now.

“This may be the most complicated 10-year-treasury yield data the market has ever seen, but no matter how good the economic data is, COVID is still here,” said Logan Mohtashami, lead analyst at HousingWire.

“When you look at two other massive economies, Germany and Japan, Germany’s 10-year-yield is in the negative. Our bond yields look much better than theirs so we can’t in a sense be at a 3% mortgage rate when the gap between ours and Germany’s yields are too far apart. There has to be balance.”

Beyond the 10-year-yield, two other yields exist in the market: retail and wholesale that fluctuate in the primary and secondary market, respectively, and which both have tightened recently.

“The reasons for why those spreads might have tightened is simply less frenzied retail market profit margins have come down a little bit in the retail market, and investors are a little bit more willing to bear the optionality of mortgages on the Treasury,” said Bill Emmons, economist for the Federal Reserve of St. Louis.

In wholesale, buyers of federally guaranteed mortgage-backed securities (MBSs) factor two financial components into the price they are willing to pay for MBSs — compensation for the pure time value of the money being invested and compensation for the interest-rate risk associated with mortgage investments, Emmons explained.

While time value is typically approximated by the yield on a Treasury security of equivalent duration i.e. the 10-year Treasury, risk compensation is more effected by mortgage borrowers prepaying their mortgage principal at face value at any time without penalty.

“People that had been looking to invest in treasuries or MBSs last year when yields were so low they were struggling to generate the kind of income they need to fund their liabilities in some cases,” said Mike Fratantoni, chief economist for the Mortgage Bankers Association. “When our yields look much more attractive than those of the rest of the world, mortgage rates get to a level on the investor side that generate a lot more interest, but we are going to go through periods where they plateau or dip back down as we watch the market.”

Keeping an eye on inflation

While investors study the bond numbers in other countries, the Federal Reserve’s adjustments on inflationary policies are keeping them just as busy.

In April, the Federal Open Market Committee left future economic policies virtually unchanged at its monthly meeting, indicating it has not made any near-term plans to taper its asset purchases of Treasury– and mortgage-backed securities while it awaited data on vaccine distribution, employment and inflation numbers.

The Fed mentioned that inflation had in fact “risen” but attributed the higher readings to “transitory factors.”

Overall, while March posted hopeful signs of a recovering economy, Fed Chairman Jerome Powell said it will take a string of good months before the Fed chooses to roll back any monetary policies.

“There is growing concern about what’s happening with inflation,” Fratantoni said. “Consumer inflation expectations are starting to increase as well so or the next couple of months bond investors are going to start to worry a bit more about both the impact of faster growth and faster inflation.”

Despite the lackluster unemployment report in April, the consumer price index still estimated inflation hitting 4.2% on a year over year basis. Typically, mortgage rates respond to this kind of data, and in theory, should have, given the historic number for core inflation as well.

When mortgage rates failed to pick up in the last month, savvy homebuyers jumped back on them. But even with rates slipping to previous lows, borrowers are still battling it out in the bidding trenches on overheated prices. April economic data for home sales showed year over year numbers are still above those in 2020, but beginning to dip sequentially.

“The inflation data should moderate as production levels catch up with the COVID-19 backlog,” Mohtashami said. “So, we have hotter-than-normal inflation data, and rates are still low, even with the rise of the 10-year yield. COVID-19 has kept global bond yields low in 2021, but for 2022, this no longer works as a legitimate reason.”

Source: housingwire.com

Apache is functioning normally

Housing is the largest expense in the budget of most families. But how much is too much to spend on shelter? An article in Saturday’s New York Times contains a shocking example of one woman who crossed the line:

What she got was a mortgage she could not afford. Toward the $385,000 cost, [Christina] Natale made a down payment of $185,000, a little less than what she took away from the sale of her grandfather’s home. The loan that made up the difference, with closing costs, broker’s fee, taxes and insurance, meant a monthly bill of $1,873.96, about $100 less than her monthly take-home pay as an administrative assistant.

I am not unsympathetic to tales of financial hardship, but this stretches even my compassion. Ms. Natale (who has three children) took out a housing loan that left her just $100 a month for every other expense in her life. She shouldn’t need an outside voice to tell her that this was an impossible situation. (All the same, where were the outside voices?)

Although this is an extreme example, many other people buy homes only to discover they’re in over their heads, unable to make payments. How can you prevent this from happening to you?

Debt-to-Income Ratio

Fortunately, decades of financial data have produced computerized models that help to determine how much a person can afford to spend on housing and debt. To learn more about this, I recently spoke with Robb Severdia of Guarantee Mortgage in Portland. I asked him to describe how the process works. (If I have anything wrong here, it’s my fault, not Severdia’s.)

Traditionally, lenders have used the debt-to-income (DTI) ratio to estimate how much a homeowner can afford to borrow. This ratio is computed by comparing your expenses to your gross (pre-tax) income. The lower the number, the better. If you make $3,000 a month before taxes, and you pay $300 toward debt, your debt-to-income ratio is 10%.

Banks and mortgage brokers look at two numbers:

  • The “front-end” debt-to-income ratio, which includes total housing expenses: mortgage principal, interest, taxes, and insurance.
  • The “back-end” debt-to-income ratio, which includes all of the above plus other debt payments: auto loans, student loans, credit cards, etc.

When a prospective borrower submits her paperwork, the computer evaluates it, applying statistical models to be sure the proposed debt load falls within accepted ranges. After this automated process, the loan proceeds to manual underwriting, where a human screens the application and makes the ultimate determination to approve or deny the loan.

Industry-standard debt-to-income ratios drive this process.

Lending Limits

When we bought our first home in 1994, everyone involved in the transaction told us that our front-end debt-to-income ratio should be 28% or less. That is, we should pay no more than 28% of our gross income toward housing expenses. The back-end ratio was 36%, which meant that our housing expenses and debt payments combined should total less than 36% of our income.

Example: Our gross (pre-tax) income in 1994 was roughly $60,000, or about $5,000 per month. To stay under the 28% front-end debt-to-income guideline, we could afford housing expenses of no more than $1,400 per month, including insurance and taxes.Because Kris had student loans and I had credit card debt, we couldn’t get close to the 28% front-end DTI ratio because it would push us over the 36% back-end. Our high debt-load meant we had less to spend on a house. Our eventual payment was $1,086 per month.

When we bought our new home in 2004, the debt-to-income ratios had changed. “That 28% figure is old,” we were told. “Most people can go as high as 33%.” The back-end ratio had been raised to 38% — and even to 41% in some models!

From what I understand, debt-to-income guidelines have gradually become more relaxed over the years. Here’s what I could puzzle together about the history of DTI (I would love to have clarifications or corrections to this list):

  • Reportedly, during the 1970s (before credit-card debt became common), DTI wasn’t split between front-end and back-end. There was only one ratio, and it was 25%. If your mortgage, taxes, and insurance were less than 25% of your income, it was assumed you could afford the payment.
  • In The New Rules of Money, Ric Edelman writes that the lending limits “used to be” 22% and 28%. I’m guessing that this must have been the rule-of-thumb during the 1980s.
  • When we bought our first home in the mid-1990s, the front-end ratio was 28% and the back-end ratio was 36%.
  • By 2004, those ratios has increased again to 33% and 38%, respectively. (To qualify for an FHA loan, your front-end DTI is limited to 29%, and the back end is capped at 41%.)

A 5% increase may not seem like a big deal, but when you’re talking about a house payment, it’s huge. Remember: 5% of a $60,000 income is $3,000 per year, or $250 a month. Many foreclosures occur because people take on housing payments that are as little as $250 a month more than they can afford.

Afraid to Say “No”

During my conversation with Robb Severdia, I asked him about the growing debt-to-income ratios. He acknowledged that he’d seen the numbers rise during his decade in the industry. “Banks feel they need to increase the limits in order to be more competitive,” he explained.

“I think that in most cases, it’s a bad idea for borrowers to push that 41% back end,” Severdia said. “It might make sense in some instances, but it can be a recipe for disaster.” In other words, give yourself a margin for error. Instead of basing your home budget on a 33% front-end debt-to-income ratio, consider dropping that to 28%. You won’t be able to afford as big of a mortgage, but you won’t feel as pinched by the payments, either.

I asked Severdia how people like Christina Natale from the New York Times story were able to get mortgages that amounted to more than half their income. “People are afraid to say ‘no’,” he told me. “They were afraid to lose the deal.” Thus the subprime mortgage crisis.

In The Automatic Millionaire Homeowner, David Bach warns:

You should generally assume that the amount the bank or mortgage company is willing to loan you is more than you should borrow. […] Don’t fool around with this. Do the math. Be realistic about your situation. Don’t pretend you’re in better shape than you really are.

Nobody cares more about your money than you do. Your real-estate agent, your mortgage broker, and the bank all have a vested interest in encouraging you to buy as much house as possible. Their incomes depend upon it. Listen to what they have to say, but make your decisions based on your own knowledge of the situation.

Better Safe Than Sorry

Homeowners are often admonished to “buy as much house as you can afford”. There’s some merit to that statement — in general, housing prices do increase, as does personal income. As a result, your mortgage payments generally become more affordable.

The problem, of course, is that when you buy as much house as you can afford, you’re left without a buffer. What if you lose your job? What if you’re forced to sell your home, but housing prices have dropped? I think it makes more sense to buy as much house as you need, keeping the conventional debt-to-income ratios as ceilings.

Ultimately, it doesn’t matter what the guidelines are. What matters is what you can afford, what you’re comfortable paying. Just because conventional wisdom says you can take out a $1400 monthly housing payment on your $60,000 annual income doesn’t mean you have to do it.

Foreclosure photo by respres.

Source: getrichslowly.org

Apache is functioning normally

For many people, that monthly mortgage payment can be their biggest recurring bill. It may be the main expense that guides the development and management of their monthly budget, because that is an important bill to pay on time.

Prevailing wisdom says that your mortgage payment shouldn’t be more than 28% of your gross (pre-tax) monthly pay. But whatever that sum actually is, you may be wondering how to shave down the amount. Think about it: A lower mortgage payment could reduce your financial stress. And it can also open up room in your budget to allocate more money towards shrinking other debt, pumping up your emergency fund, and saving for retirement or other goals.

Here, you’ll learn more about your mortgage payment and possible ways to lower it.

What Is a Mortgage Payment?

A mortgage payment is a sum you typically pay every month, but it’s more than just a bill. It reflects an agreement between you and your lender that you have borrowed money to buy or refinance a home, and in exchange, you’ve agreed to pay back the sum with interest over time. If you fail to keep up with your payments, the lender may have the right to take your property.

There are typically four parts of your monthly payment: the loan principal, the loan interest (which is how the lender makes money), taxes, and insurance fees.

A mortgage payment may be a fixed rate, meaning your payment stays the same, month after month, year after year. Or it might be an adjustable rate, meaning the interest and therefore the payment can change at regular intervals.

Pros and Cons of Lowering Your Mortgage Payments

There are upsides and downsides to lowering your mortgage payments.

On the plus side, lowering your mortgage means you likely have more money to apply elsewhere. You might apply the freed-up funds to:

•   Pay down other debt

•   Build up your emergency fund

•   Put more money towards retirement savings

•   Use the cash for discretionary spending.

On the other hand, there are downsides to consider too:

•   You might wind up paying a lower amount over a longer period of time, meaning your debt lasts longer

•   You could pay more in interest over the life of the loan

•   If a lower monthly payment means you are not paying your full share of interest due, you could wind up in a negative amortization situation, in which the amount you owe is going up instead of down.

6 Ways to Lower Your Mortgage Payments

Now that you know a bit about how mortgage payments work and the pros and cons of lowering your mortgage payments, consider these ways you could minimize your monthly amount due.

Recommended: How to Pay Off a 30-Year Mortgage in 15 Years

1. Give Your Mortgage a Bonus

If you get a bonus or a windfall, consider throwing some of that money at your mortgage. If you are in a position to make a major lump-sum payment on your home loan, you may benefit from mortgage recasting.

With recasting, your lender will re-amortize the mortgage but retain the interest rate and term. The new, smaller balance equates to lower monthly payments. Worth noting: Many lenders charge a servicing fee and have equity requirements to recast a mortgage.

Other similar options:

•   Make a lump-sum payment toward the mortgage principal (say, if you inherit some money or get a large bonus at work)

•   Make extra payments on a schedule or whenever you can.

It’s a good idea to tell your lender that you want to put the extra money toward the principal and not the interest. Paying extra toward the principal provides two benefits: It will slowly reduce your monthly payment, and it will pare the total interest paid over the life of the loan.

Refinance your mortgage and save–
without the hassle.

2. Reap Rental Income at Home

You could lower how much you pay out-of-pocket for your mortgage by bringing in rental income and putting it towards that monthly bill. You’re not lowering how much you owe, but you are using your home to bring in another income stream.

There are two common methods: “house hacking” (generating income from your property) and adding an accessory dwelling unit (ADU).

•   House hacking can mean buying a two- to four-unit multifamily building for little money down and living in one of the units. Multi-family homes with up to four units are considered residential when it comes to financing. Owner-occupants may qualify for and opt for Federal Housing Administration (FHA) loans, Veterans Affairs (VA) loans, or conventional financing.

Some people house-hack a single-family home, which just translates to having housemates or short-term rental guests.

•   An ADU is another option for bringing in rental money to use towards your mortgage. This secondary dwelling unit on the same lot as a primary single-family home could be a detached cottage, a garage or basement conversion (that is, an in-law apartment or similar), or an attached unit.

With any planned addition or renovation to create an ADU, you might want to estimate return on investment — how much you’d charge and how long it would take to recoup the cash you put in before turning a profit.

3. Extend the Term of Your Mortgage

If your goal is to reduce your monthly payment — though not necessarily the overall cost of your mortgage — you may consider extending your mortgage term. For example, if you refinanced a 15-year mortgage into a 30-year mortgage, you would amortize your payments over a longer term, thereby reducing your monthly payment.

This technique could lower your monthly payment but will likely cost you more in interest in the long run.

(That said, just because you have a new 30-year mortgage doesn’t mean you have to take 30 years to pay it off. You’re often allowed to pay off your mortgage early without a prepayment penalty by paying more toward the principal.)

4. Get Rid of Mortgage Insurance

Mortgage insurance, which is needed for some loans, can add a significant amount to your monthly payments. Luckily, there are ways to eliminate these payments, depending on which type of mortgage loan you have.

•   Getting rid of the FHA mortgage insurance premium (MIP). Consider your loan origination date that impacts when you can get rid of the extra expense of mortgage insurance:

•   July 1991 to December 2000: If your loan originated between these dates, you can’t cancel your MIP.

•   January 2001 to June 3, 2013: Your MIP can be canceled once you have 22% equity in your home.

•   June 3, 2013, and later: If you made a down payment of at least 10% percent, MIP will be canceled after 11 years. Otherwise, MIP will last for the life of the loan.

Another way to shed MIP is to refinance to a conventional loan with a private lender. Many FHA homeowners may have enough equity to refinance.

•   Getting rid of private mortgage insurance (PMI) If you took out a conventional mortgage with less than 20% down, you’re likely paying PMI. Ditching your PMI is an excellent way to reduce your monthly bill.

To request that your PMI be eliminated, you’ll want to have 20% equity in your home, whether through your own payments or through home appreciation.

Thinking about starting a new home renovation project? Use this Home Improvement Cost Calculator to get an idea of what your project will cost.

Your lender must automatically terminate PMI on the date when your principal balance reaches 78% of the original value of your home. Check with your lender or loan program to see when and if you can get rid of your PMI.

5. Appeal Your Property Taxes

Here’s another way to lower your mortgage payments: Take a closer look at your property taxes. Your property taxes are based on an assessment of your house and land conducted by your county’s tax assessor. The higher they value your property, the more taxes you’ll pay.

If you think you’re paying too much in taxes, you can appeal the assessment. If you do, be prepared with examples of comparable properties in your area valued at less than your home. Or you may also show a professional appraisal.

To challenge an assessment, you can call your local tax assessor and ask about the appeals process.

6. Refinance Your Mortgage

One of the best ways to reduce monthly mortgage payments is to refinance your mortgage. Refinancing (not to be confused with a reverse mortgage) means replacing your current mortgage with a new one, with terms that better suit your current needs.

There are a number of signs that a mortgage refinance makes sense, such as lower interest rates being offered or the desire to secure a fixed rate when you have an adjustable rate mortgage.

Refinancing can result in a more favorable interest rate, a change in loan length, a reduced monthly payment, and a substantial reduction in the amount you owe over the life of your mortgage. Do note, however, that there are often fees for refinancing your mortgage.

Tips on Lowering Your Mortgage Payment

If you’re serious about lowering your mortgage payments, consider these methods:

•   Refinance to get a lower rate or other changes in your mortgage’s terms

•   Apply a windfall (a tax refund, say, or a bonus) to your mortgage’s principal

•   Reach enough equity in your home to drop mortgage insurance

•   Make extra mortgage payments or higher mortgage payments (this can build equity or pay off the loan sooner, saving you interest)

•   Ask about loan modification or forbearance programs if you are struggling to make payments.

Recommended: First-time Homebuyer Programs

The Takeaway

How to lower your mortgage payment? There are several possible ways. And who wouldn’t love to shrink their house payment? You might look at strategies to build equity and ditch mortgage insurance, extend the terms of your loan, or refinance to reduce your monthly payment.

If refinancing could help, see what SoFi offers. Both refinancing and cash-out refinancing are possible. And SoFi also offers a range of flexible home mortgage loans with competitive rates to help you make homeownership that much more affordable. Plus, our online process is fast and simple.

Ready to see how much simpler a SoFi Home Mortgage Loan can be?

FAQ

How can I make my mortgage payment go down?

There are several ways to lower your monthly mortgage payment. A few options: You could refinance at a lower rate or longer term, or you could build enough equity to forgo mortgage insurance.

How can I lower my house payment without refinancing?

To lower your house payment without refinancing, you could appeal to lower your property taxes; you might apply a windfall to lower your principal; or you could rent out part of your property to bring in more income.

What is the average mortgage payment?

According to the C2ER’s 2022 Annual Cost of Living index, the average monthly mortgage payment in the U.S. is $1,768.

SoFi Mortgages
Terms, conditions, and state restrictions apply. Not all products are available in all states. See SoFi.com/eligibility for more information.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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Source: sofi.com

Apache is functioning normally

Apache is functioning normally

On August 1, 2020, I took out a 7/1 adjustable rate mortgage (ARM) at 2.125%. I could have gotten a 30-year fixed-rate mortgage for 2.75%. However, I wanted to save 0.625% in interest.

Years later, mortgage rates have zoomed higher thanks to the pandemic, massive stimulus spending, a war in Ukraine, and supply chain issues. Inflation reached a 40-year high in June 2022.

Do I regret my decision to get an adjustable-rate mortgage over a fixed-rate mortgage?

My answer is “no,” and let me tell you why.

Why I’m Fine With An ARM Despite Higher Mortgage Rates

Back in 2020, we just had our second baby and wanted a fully remodeled home to house our family. We had been living in a home that was in the middle of a long gut remodel. Given I thought the remodel would take longer than expected, I decided to pounce on a nicer home.

I fully admit I did not anticipate inflation and mortgage rates surging to the levels we saw in 2022. However, despite higher mortgage rates, I still have no regrets getting an ARM.

I know I’m in the minority and will likely get heat for my views. But hear me out.

1) I’m saving money with an ARM

Instead of paying 2.75% for a 30-year fixed mortgage, I’m paying 2.125% for a 7/1 ARM. Every year that goes by, I’m saving almost $10,000 in interest expense.

Over the seven-year fixed duration, I will likely end up saving ~$65,000 in gross mortgage interest expense. Saving money feels great, not bad!

Even if I were to pay a much higher mortgage rate after my ARM expires, I have a $65,000 buffer before I start paying more due to getting an ARM. I calculate that break even period will start in the eleventh year of my ARM, even if mortgage rates stay at current elevated levels.

2) The house has appreciated in value

Buying the house in mid-2020 turned out to be a good move. The value of the house is up between $300,000 – $500,000, even after a 5% – 10% slump since 2022.

The combination of saving money on mortgage interest expense and experiencing home price appreciation feels lucky. The home price appreciation dwarfs any amount of increased mortgage payments I will need to pay after my ARM expires.

If the house depreciated in value, then I would still feel better knowing that I’m paying a lower mortgage interest than I had to. But of course, I wouldn’t feel as good.

3) ARM interest increases have limits

All ARMs should have a limit on how much the mortgage rate can increase the first year after the fixed-rate duration is over. Subsequent years also have interest increase limits. There is also a maximum mortgage interest rate limit increase for the life of the loan.

In my case, my mortgage rate can go up a maximum of 2% in year eight, another 2% in year nine, and up to a maximum interest rate of 7.125%.

Below is an example of an ARM interest limit increase of an $850,000, 5/1 ARM at 2.375%.

As you can see from the example above, the mortgage increases can go up every year up to a limit. Therefore, you can model out potential worst-case scenarios in the future to see if you’ll be able to afford your mortgage.

Thankfully, most people get raises and grow their net worths over time. As a result, they will be better able to handle higher payments in the future.

4) Mortgage principal gets paid down over time

Every month, $3,450 of my mortgage payment goes to paying down principal. In 84 months, when my 7/1 ARM expires, I will have paid off around $330,000 in principal.

If mortgage rates are higher in year eight, then I will pay a higher mortgage interest rate of up to 4.125% for one year. But I will also be paying interest on a ~20% lower mortgage balance.

As a result, my actual monthly payment will only increase by about one percent. Even if my mortgage interest rate increases by another 2% to 6.125% in year nine, my monthly mortgage payment will only increase by about nine percent.

The worst-case scenario of paying one percent to nine percent more in years eight and nine will be hardly noticeable. The average worker who receives two percent raises a year will easily be able to afford these higher payments.

5) Have the option to refinance

Nobody knows the future. However, before my ARM expires on August 1, 2027, I have the option to refinance.

It’s unlikely I can refinance to a similarly low rate of 2.125%. However, there’s a good chance I could refinance to another 7/1 ARM that’s under 4.125%, i.e. less than my first year adjustment’s maximum mortgage rate.

If I can do a no-cost refinance at a low rate, even better. Although you pay a higher mortgage rate in a no-cost refinance, if the mortgage rate is attractive, you’re still winning. Further, you retain the option to refinance again without feeling bad that you paid fees for refinancing.

I believe the long-term trend for inflation and interest rates is down. We’ve already seen inflation peak in June 2022 and come down every month since. I’m confident that sometime between now and August 1, 2027, I’ll have another window to refinance at an attractive mortgage rate.

Below is a chart that shows the historical trend of the average 30-year fixed-rate mortgage. Rates have been going down since the 1980s.

6) Fixed-rate duration of an ARM more closely matches my ownership duration

If I thought I was really buying a forever home in mid-2020, I would have been more inclined to lock in a 30-year fixed-rate mortgage and pay it down sooner. Instead, I got a 7/1 ARM partially because we will unlikely live in the house for much longer than seven years.

Based on my homeownership track record, we move every two-to-ten years given I’m an avid investor in real estate. My holding period is lower than the median homeownership tenure of roughly twelve years today.

I believe in buying a primary residence, updating it, living in it for at least two years to get the tax-free profits up to $250,000/$500,000 in profits, renting it out, and then buying another home. Over the course of a regular lifetime, a typical household could amass a four rental property portfolio by age 60 and retire comfortably off rental income.

Since 2003, I’ve been buying middle-class homes because that’s what most households can afford. I believe this is a smart way to invest in real estate. Investing in luxury property does not give as high of a return on investment.

Below is the average homeownership tenure from 2005 to 2022 according to Redfin. At about 12 years today, getting a 30-year fixed-rate mortgage is a big 18-year overshoot for the average homeowner. I’ve only owned my current home for three years and I’m already itching to upgrade homes. Know thyself!

Although I love our current house, I will likely be disappointed if we are still living in it seven years from now. This means we will have not relocated to Oahu. It will also mean we lived too frugally. In seven years, the house will likely decline to less than ten percent of our net worth.

As someone who has entered into his decumulation phase of life, my goal is to try and spend more money, not less. And one of the easiest ways to spend more money is to own a nicer house.

7) The worst case of paying more isn’t so bad

With principal paydown and the savings I’m accumulating from having a seven-year adjustable-rate mortgage, I will have a large buffer in case mortgage rates skyrocket in year eight and beyond. But let’s say mortgage rates do surge long after my savings buffer is exhausted. Not a big deal.

Chances are high that ten years after I first took out the 7/1 ARM, my net worth will be higher. That’s usually what happens when you continuously save and invest.

In an high inflation, high mortgage rate environment, we also get to earn higher risk-free income through Treasury bonds, CDs, and money market funds. For example, today we can all earn over 5% risk-free in one-year Treasury bonds. We can ride the inflation wave too.

Even if your absolute mortgage amount goes up, if the mortgage payment as a percentage of your income goes down, you will feel fine. There’s a reason why I encourage everyone to follow my 30/30/3 home buying rule.

8) An ARM keeps me motivated to grow more wealth by a particular time

Having an ARM motivates me to pay down debt quicker. When you have a shorter time horizon to get something done, you tend to be more focused.

If I had a 30-year fixed-rate mortgage, I wouldn’t work as hard, pay as close attention to my finances, or pay down debt as intentionally. With a 5/1, 7/1, or 10/1 ARM, I treat the introductory fixed-rate period as a deadline to earn as much as possible and/or pay down as much mortgage debt as possible.

One of the key tenets of a Financial Samurai is to achieve financial independence sooner, rather than later. Taking thirty years to pay off a mortgage is not the way. An ARM motivates me to take more action to secure my financial future.

Congrats To All Who Refinanced Or Got A New Mortgage At The Bottom

Refinancing or taking on a mortgage in 2020 or 2021 is one of the all-time great financial moves. It’s hard to see mortgage rates getting back to those levels again.

Whether you got a 30-year fixed-rate mortgage or an adjustable-rate mortgage, feel good knowing you got a historically low rate. The double benefit of living cheaply while experiencing property price appreciation is wonderful.

Although paying off your home might not provide joy long-term, when you finally do, you’ll appreciate that you were able to borrow so cheaply.

Despite an increase in mortgage rates, my preference towards adjustable rate mortgages has not changed. Based on my 20+ years of investing in real estate, I don’t want to pay more money on debt than I have to.

Reader Questions And Answers

Does anybody regret getting an ARM? If so, why? Does anybody regret getting a 30-year fixed-rate mortgage? If so, why? Do you think mortgage rates and inflation will stay elevated in 2027 and beyond?

If you’re looking to refinance or get a better mortgage rate, shop around online at Credible. Credible has multiple lenders who will offer real quotes and compete for your business. Also contact your existing bank to see what it has to offer. If you have good credit, you should get a lower rate than the national averages.

Join 60,000+ others and sign up for the free Financial Samurai newsletter and posts via e-mail. Financial Samurai is one of the largest independently-owned personal finance sites that started in 2009. 

Source: financialsamurai.com

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The mortgage industry has its own language, and in order to understand it, homebuyers need to learn different acronyms and jargon when shopping for a home loan. A typical home loan payment or mortgage payment involves a single payment, which is the sum of four different line items: the loan principal, interest, taxes, and insurance – also referred to as PITI. 

Before you set your sights on a home, know if you can afford the costs by learning what PITI is and how it impacts your monthly mortgage payments.

What does PITI stand for? 

PITI stands for the loan principal, interest amount, taxes, and insurance on your home – the four major elements that make up mortgage payments. 

Homebuyers often underestimate the true cost of homeownership by failing to take into account property taxes and homeowners insurance. It’s crucial that you budget for all the components of your mortgage payment before purchasing a home.

What is PITI? The four components

Now that we know what PITI stands for, let’s break down each of the four components and analyze the individual elements that make up your monthly mortgage payment.

1) Principal

The mortgage principal is the loan amount before any interest is calculated. This is the base amount of your home purchase price minus any down payment you make. 

We’ll use a hypothetical home purchase for reference; if you buy a home for $450,000 with a 20% down payment ($90,000), your mortgage principal amount will be $360,000.

Over your mortgage term, you pay substantially more than the original $360,000 to the lender in the form of loan interest. The principal is the base amount used for loan calculations to determine if they will extend a loan to you. 

2) Interest

Your mortgage interest rate is what you pay the lender as part of your monthly mortgage payment to borrow the funds to purchase your home. The mortgage lender calculates interest as a percentage of your outstanding principal. If your principal loan is for $360,000 and your lender charges you an interest rate of 6%, this means that you will pay $21,600 (6% of $360,000) in interest for the first year of your mortgage.

Your mortgage interest and principal payments are itemized on a mortgage amortization table. The amortization charts show how much each mortgage payment pays down your principal and interest. When you first start making mortgage payments, most of your monthly payment goes toward interest instead of the principal. 

This split shifts over time, and eventually, the amount you pay toward interest decreases, and more is paid toward the principal. As the principal amount of your loan decreases, you start to earn equity on your home. Equity is the portion of your home that you own outright. Your interest decreases as well, as you only pay interest on the principal amount you have not paid off.

For our example, you will pay $21,600 in interest over the first year of your $360,000 mortgage. By the time you have paid down $260,000 of that principal, your principal amount will be $100,000; at that point, you’ll pay interest of $6,000 annually (6% of $100,000).

3) Taxes

When you own your house, you pay taxes on the property to your local government to maintain roads, emergency services, police, firefighters, schools, and more. Buyers often overlook property taxes when estimating homeownership costs, but it is important to consider this recurring annual cost when you’re searching for your new home. Property taxes vary by location and are the most expensive tax homeowners pay. Taxes may be higher in a newer neighborhood or an area coveted by many homeowners. They are often less if you live just outside coveted neighborhoods and in rural areas. 

The amount of property tax you pay is determined by the local property tax rate and the value of your home. A general guideline to estimate property taxes is to allocate approximately $1 for every $1,000 of your home’s value, paid on a monthly basis.For example, if your home is worth $450,000, you can expect to pay around $450 per month in property taxes or $5,400 per year. 

As part of the home purchase process, most states require that you get an unbiased, official appraisal to estimate your taxes accurately. Your lender usually orders the home appraisal and includes the cost in their list of closing costs. After you close on your home purchase, keep in mind that your local government will regularly reassess properties every few years for tax purposes, which could lead to a change in your tax bill.

4) Insurance

The “insurance” component of PITI refers to homeowner’s insurance and, when it’s required, private mortgage insurance (PMI). Let’s discuss each of these concepts in more detail. 

Private mortgage insurance (PMI)

Your PMI rates depend on how much of a down payment you made and your credit score. If you’re putting down less than 20% on a conventional loan, you’re required to pay for private mortgage insurance (PMI), which protects the lender if you default on your mortgage payments. Once you build at least 20% equity in your home — and your loan-to-value (LTV) ratio is 80% or less — you can get rid of PMI. For FHA loans, a similar mortgage insurance premium has to be paid throughout the life of the loan on any FHA-backed mortgage loan.

If your PMI comes in at a rate of 1%, here’s how you’d calculate a mortgage of $360,000: $360,000 x 1% = $3,600 per year; $3,600 ÷ 12 monthly payments = $300 per month.

Homeowners insurance

Most mortgage lenders require a homebuyer to purchase and maintain homeowners insurance over the entire loan term. Homeowners insurance covers you and the lender if something catastrophic happens to the home, and you need to rebuild or move. Most homeowners insurance policies cover your home in the event of a break-in, fire, or storm damage. 

Most insurance companies require you to buy additional coverage for damage from earthquakes or flooding. You can also purchase insurance riders to cover items of significant value, such as an expensive musical instrument, art, or jewelry. If you buy a condominium, you’ll also pay a homeowners association fee. Your lender may consider your HOA fee your insurance as the HOA carries its own insurance that covers the building, and thus you may not need another policy. 

Property insurance amounts can vary among different insurances. It’s wise to shop around after the seller accepts your purchase contract, and before you close on the property, to get a good idea of reasonable rates. Insurance companies consider these factors when calculating an insurance premium:

  • The home’s value
  • Whether you live in an urban area or a rural area
  • Whether you live in an area with high climate risk
  • How close your home is near a fire department or fire hydrant 
  • Whether you have an insurance risk on your property, i.e., something could injure children, such as a trampoline, pool, or specific dog breed 
  • How many insurance claims you make each year for other types of insurance

When estimating your homeowner’s insurance costs, it’s helpful to keep a general rule of thumb in mind. On average, you can anticipate paying approximately $3.50 per every $1,000 of your home’s value in annual homeowner’s insurance premiums. For instance, if your property is valued at $450,000, you can expect to pay around $1,575 per year for insurance coverage, which translates to roughly $131 per month.

How to calculate PITI

Before you start your search for a house, it’s a good idea to calculate PITI to determine your price range and help you find a mortgage option that will fit your budget. The exercise will make you a more rational home buyer and keep you from falling in love with a house outside your price range. 

The simplest way to calculate PITI is by using an online monthly mortgage calculator. Redfin’s mortgage calculator includes the principal and interest, taxes, insurance, HOA, and PMI. You can also add in your location for more accurate estimates.

PITI and the 28% Rule

Your PITI gives you a rough idea of what purchase price range you can afford. One way to identify a purchase price within manageable limits is to use the housing expense ratio. To ensure your ongoing ability to make your mortgage payments, home finance experts typically recommend that your housing costs should be equal to or below 28% of your monthly household budget. If your PITI is more than 28% of your monthly budget, your lender may require you to pay for additional mortgage insurance.

In our example, you can estimate your housing expense ratio by dividing your PITI by your total monthly income. If your household income is $10,000 a month, your PITI will make up about 28% of your monthly budget, well within recommended guidelines. ($2,800/$10,000 = 28%.)

Keep in mind that PITI may just account for just some of your monthly expenses when owning a home. Depending on where you live and how you are paying for your home, there may be additional costs to consider. Additionally, the components that make up PITI are broadly defined here; there is often more complexity that goes into each part of PITI.

How PITI impacts loan approval

During the home buying process, it can be easy to trick yourself into thinking you can afford a more expensive home if you only look at your mortgage’s principal and interest cost without considering the total PITI with taxes and insurance. 

For instance, let’s take a 30-year mortgage on a $450,000 property, assuming a property tax rate of 1.25% ($5,625 per year) and an annual homeowners insurance premium of $3,600. In this scenario, your monthly financial commitment would go beyond just the principal and interest amount, as you would need to allocate an additional $581 to cover taxes and insurance. Understanding and accounting for these factors will provide you with a comprehensive understanding of the actual costs involved in homeownership.

Here is a breakdown of the example discussed above. 

Principal and Interest PITI
Interest rate 7% 7%
20% down payment $90,000 $90,000
Property taxes N/A $450
Homeowners insurance N/A $131
Private mortgage insurance N/A N/A
Monthly payment $1,800 $2,381

How DTI factors in

The principal balance will factor into your debt-to-income (DTI) ratio. Your DTI ratio gives lenders an idea of how capable you are of managing money and the likelihood that you will consistently make your monthly payments. To determine your DTI, the lender uses your total minimum monthly debt obligation and divides it by your gross monthly income to arrive at a percentage. This calculation also includes payments on credit card accounts, auto loans, student loans, and other recurring debt payments. Lenders consider you a higher risk if your DTI ratio exceeds 43%, some lenders will allow a DTI as high as 50%. 

Don’t overlook other housing costs

PITI is just one fundamental concept to understand before applying for a mortgage. As you consider how much house you can afford, you’ll also need to plan for additional costs typically associated with homeownership. These include HOA or condo fees, which can range from $100 to $1,000 per month, with an average of $200 to $300. Additionally, budgeting for repairs and maintenance is crucial, with a general guideline of saving 1% to 5% of your home’s value annually. For a newer $450,000 home, this would mean setting aside $4,500 to $22,500 per year. Utility bills for electricity, water, gas, sewer, cable, trash, and internet should also be factored in, and contacting the utility company or asking the seller or neighbors can help estimate these costs.

The bottom line on PITI

Buying a home is very exciting, but before signing your mortgage contract, know what payment amount you can afford based on PITI and other monthly costs. The more you understand the home buying and mortgage process and the total cost of homeownership, the easier it will be to finalize your purchase decision. Your home purchase represents an important milestone in your life – avoid confusion and uncertainty by gaining a solid understanding of PITI and the cost of homeownership. 

Source: redfin.com

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Table of Contents
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This article will explain the Big Short and the 2008 subprime mortgage collapse in simple terms.

This post is a little longer than usual–maybe give yourself 20 minutes to sift through it. But I promise you’ll leave feeling like you can tranche (that’s a verb, right?!) the whole financial system!

Key Players

First, I want to introduce the players in the financial crisis, as they might not make sense at first blush. One of the worst parts about the financial industry is how they use deliberately obtuse language to explain relatively simple ideas. Their financial acronyms are hard to keep track of. In order to explain the Big Short, these players–and their roles–are key.

Individuals, a.k.a. regular people who take out mortgages to buy houses; for example, you and me!

Mortgage lenders, like a local bank or a mortgage lending specialty shop, who give out mortgages to individuals. Either way, they’re probably local people that the individual home-buyer would meet in person.

Big banks, such as Goldman Sachs and Morgan Stanley, who buy lots of mortgages from lenders. After this transaction, the homeowner would owe money to the big bank instead of the lender.

Collateralized debt obligations (CDOs)—deep breath!—who take mortgages from big banks and bundle them all together into a bond (see below). And just like before, this step means that the home-buyer now owes money to the CDO. Why is this done?! I’ll explain, I promise.

Ratings agencies,
whose job is to determine the risk of a CDO—is it filled with safe mortgages,
or risky mortgages?  

Investors, who buy part of a CDO and get repaid as the individual homeowners start paying back their mortgage.

Feel lost already? I’m going to be a good jungle guide and get you through this. Stick with me.

Quick definition: Bonds

A bond can be
thought of as a loan. When you buy a bond, you are loaning your money. The issuer of the bond is borrowing your money. In exchange for borrowing your money, the
issuer promises to pay you back, plus interest, in a certain amount of time.
Sometimes, the borrower cannot pay the investor back, and the bond defaults, or fails. Defaults are not
good for the investor.

The CDO—which is a bond—could hold thousands of mortgages in it. It’s a mortgage-backed bond, and therefore a type of mortgage-backed security. If you bought 1% of a CDO, you were loaning money equivalent to 1% of all the mortgage principal, with the hope of collecting 1% of the principal plus interest as the mortgages got repaid.

There’s one more key player, but I’ll wait to introduce it.
First…

The Whys, Explained

Why does an individual take out a mortgage? Because they want a home. Can you blame them?! A healthy housing market involves people buying and selling houses.

How about the lender;
why do they lend? It used to be
so they would slowly make interest money as the mortgage got repaid. But
nowadays, the lender takes a fee (from the homeowner) for creating (or originating) the mortgage, and then
immediately sells to mortgage to…

A big bank. Why do
they buy mortgages from lenders? Starting in the 1970s, Wall St. started
buying up groups of loans, tying them all together into one bond—the CDO—and
selling slices of that collection to investors. When people buy and sell those
slices, the big banks get a cut of the action—a commission.

Why would an investor
want a slice of a mortgage CDO? Because, like any other investment, the big
banks promised that the investor would make their money back plus interest once the homeowners began
repaying their mortgages.

You can almost trace the flow of money and risk from player to player.

At the end of the day, the investor needs to get repaid, and that money comes from homeowners.

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CDOs are empty buckets

Homeowners and mortgage lenders are easy to understand. But a big question mark swirls around Wall Street’s CDOs.

I like to think of the CDO as a football field full of empty buckets—one bucket per mortgage. As an investor, you don’t purchase one single bucket, or one mortgage. Instead, you purchase a thin horizontal slice across all the buckets—say, a half-inch slice right around the 1-gallon mark.

As the mortgages are repaid, it starts raining. The repayments—or rain—from Mortgage A doesn’t go solely into Bucket A, but rather is distributed across all the buckets, and all the buckets slowly get re-filled.

As long as your horizontal slice of the bucket is eventually surpassed, you get your money back plus interest. You don’t need every mortgage to be repaid. You just need enough mortgages to get to your slice.

It makes sense, then, that the tippy top of the bucket—which
gets filled up last—is the highest risk. If too many of the mortgages in the
CDO fail and aren’t repaid, then the tippy top of the bucket will never get
filled up, and those investors won’t get their money back.

These horizontal slices are called tranches, which might
sound familiar if you’ve read the book or watched the movie.

So far, there’s nothing too wrong about this practice. It’s simply moving the risk from the mortgage lender to other investors. Sure, the middle-men (banks, lenders, CDOs) are all taking a cut out of all the buy and sell transactions. But that’s no different than buying lettuce at grocery store prices vs. buying straight from the farmer. Middle-men take a cut. It happens.

But now, our final player enters the stage…

Credit Default Swaps: The
Lynchpin of the Big Short

Screw you, Wall Street nomenclature! A credit default swap sounds complicated, but it’s just insurance. Very simple, but they have a key role to explain the Big Short.

Investors thought, “Well, since I’m buying this risky tranche of a CDO, I might want to hedge my bets a bit and buy insurance in case it fails.” That’s what a credit default swap did. It’s insurance against something failing. But, there is a vital difference between a credit default swap and normal insurance.

I can’t buy an insurance policy on your house, on your car, or on your life. Only you can buy those policies. But, I could buy insurance on a CDO mortgage bond, even if I didn’t own that bond!

Not only that, but I could buy billions of dollars of insurance on a CDO that only contained millions of dollars of mortgages.

It’s like taking out a $1 million auto policy on a Honda Civic. No insurance company would allow you to do this, but it was happening all over Wall Street before 2008. This scenario essentially is “the big short” (see below)—making huge insurance bets that CDOs will fail—and many of the big banks were on the wrong side of this bet!

Credit default swaps involved the largest amounts of money in the subprime mortgage crisis. This is where the big Wall Street bets were taking place.

Quick definition: Short

A short is a bet that something will fail, get worse, or go down. When most people invest, they buy long (“I want this stock price to go up!”). A short is the opposite of that.

Certain individuals—like main characters Steve Eisman (aka Mark Baum in the movie, played by Steve Carrell) and Michael Burry (played by Christian Bale) in the 2015 Oscar-nominated film The Big Short—realized that tons of mortgages were being made to people who would never be able to pay them back.

If enough mortgages failed, then tranches of CDOs start to fail—no mortgage repayment means no rain, and no rain means the buckets stay empty. If CDOs fail, then the credit default swap insurance gets paid out. So what to do? Buy credit default swaps! That’s the quick and dirty way to explain the Big Short.

Why buy Dog Shit?

Wait a second. Why did people originally invest in these CDO bonds if they were full of “dog shit mortgages” (direct quote from the book) in the first place? Since The Big Short protagonists knew what was happening, shouldn’t the investors also have realized that the buckets would never get refilled?

For one, the prospectus—a fancy word for “owner’s manual”—of a CDO was very difficult to parse through. It was hard to understand exactly which mortgages were in the CDO. This is a skeevy big bank/CDO practice. And even if you knew which mortgages were in a CDO, it was nearly impossible to realize that many of those mortgages were made fraudulently.

The mortgage lenders were knowingly creating bad mortgages. They were giving loans to people with no hopes of repaying them. Why? Because the lenders knew they could immediately sell that mortgage—that risk—to a big bank, which would then securitize the mortgage into a CDO, and then sell that CDO to investors. Any risk that the lender took by creating a bad mortgage was quickly transferred to the investor.

So…because you can’t decipher the prospectus to tell which mortgages are in a CDO, it was easier to rely on the CDO’s rating than to evaluate each of the underlying mortgages. It’s the same reason why you don’t have to understand how engines work when you buy a car; you just look at Car & Driver or Consumer Reports for their opinions, their ratings.

The Ratings Agencies

Investors often relied on ratings to determine which bonds
to buy. The two most well-known ratings agencies from 2008 were Moody’s and
Standard & Poor’s (heard of the S&P
500?). The ratings agency’s job was to look at a CDO that a big bank created,
understand the underlying assets (in this case, the mortgages), and give the
CDO a rating to determine how safe it was. A good rating is “AAA”—so nice, it
got ‘A’ thrice.

So, were the ratings agencies doing their jobs? No! There are a few explanations for
this:

  1. Even they—the experts in charge of grading the
    bonds—didn’t understand what was going on inside a CDO. The owner’s manual
    descriptions (prospectuses) were too complicated. In fact, ratings agencies
    often relied on big banks to teach
    seminars     about how to rate CDOs, which is like a teacher learning how to
    grade tests from Timmy, who still pees his pants. Timmy just wants an A.
  2. Ratings agencies are profit-driven companies.
    When they give a rating, they charge a fee. But if the agency hands out too
    many bad grades, then their customers—the big banks—will take their requests
    elsewhere in hopes of higher grades. The ratings agencies weren’t objective, but instead were biased by
    their need for profits.
  3. Remember those fraudulent mortgages that the
    lenders were making? Unless you did some boots-on-the-ground research, it was
    tough to uncover this fact. It’s hard to blame the ratings agencies for not
    catching this.

Who’s to blame?

Everyone? Let’s play devil’s advocate…

  • Individuals: some people point the finger at homeowners, saying, “You should know better than to buy a $1 million house on a teacher’s salary.” I find this hard to swallow. These people, surrounded by the American home-ownership dream, were sold the idea that they would be fine. The mortgage lender had no incentive to sell a good mortgage, they only had an incentive to sell a mortgage. So, it’s hard for me to put too much blame on the homeowners.
  • Mortgage lenders: someone knew. I’m not saying that all the mortgage lenders were fully aware of the implications of their actions, but some people knew that fraudulent loans were being made, and chose to ignore that fact. For example, check out whistleblower Eileen Foster.
  • Big banks: Yes sir! There’s certainly blame here. Rather than get into all of the various money-grubbing, I want to call out one specific anecdote. Back in 2010, Goldman Sachs CEO Lloyd Blankfein testified in front of Congress. Here it is:
[embedded content]

To explain further, there are two things going on
here.

First, Goldman Sachs bankers were selling CDOs to investors. They wanted to make a commission on the sale.

At the same time, other bankers ALSO AT GOLDMAN SACHS were buying credit default swaps, a.k.a. betting against the same CDOs that the first Goldman Sachs bankers were selling.

This is like selling someone a racehorse with cancer, and then immediately going to the track to bet against that horse. Blankfein’s defense in this video is, “But the horse seller and the bettor weren’t the same people!” And the Congressmen responds, “But they worked for the same stable, and collected the same paychecks!”

So do the big banks deserve blame? You tell me. 

Inspecting Goldman Sachs

One reason Goldman Sachs survived 2008 is that they began buying credit default swaps (insurance) just in time before the housing market crashed. They were still on the bad side of some bets, but mostly on the good side. They were net profitable.

Unfortunately for them, the banks that owed Goldman money were going bankrupt from their own debt, and then Goldman never would have been able to collect on their insurance. Goldman would’ve had to payout on their “bad” bets, while not collecting on their “good” bets. In their own words, they were “toast.”

This is significant. Even banks in “good” positions would’ve gone bankrupt, because the people who owed the most money weren’t able to repay all their debts. Imagine a chain; Bank A owes money to Bank B, and B owes money to Bank C. If Bank A fails, then B can’t collect their debt, and B can’t pay C. Bank C made “good” bets, but aren’t able to collect on them, and then they go out of business. 

These failures would’ve rippled throughout the world. This explains why the US government felt it necessary to bail-out the banks. That federal money allowed banks in “good” positions to collect their profits and “stop the ripple” from tearing apart the world economy. While CDOs and credit default swap explain the Big Short starting, this ripple of failure is the mechanism that affected the entire world.

Betting more than you have

But if someone made a bad bet—sold bad insurance—why didn’t they have money to cover that bet? It all depends on risk. If you sell a $100 million insurance policy, and you think there’s a 1% chance of paying out that policy, what’s your exposure? It’s the potential loss multiplied by the probability = 1% times $100 million, or $1 million.

These banks sold billions of dollars of insurance under the assumption that there was a  5%, or 3%, or 1% chance of the housing market failing. So they had 20x, or 30x, or 100x less money on hand then they needed to cover these bets.

Turns out, there was a 100% chance that the market would fail…oops!

Blame, expounded

Ratings agencies—they should be unbiased. But they sold themselves off for profit. They invited the wolves—big banks—into their homes to teach them how to grade CDOs. Maybe they should read a blog to explain the Big Short to them. Of course they deserve blame. Here’s another anecdote of terrible judgment from the ratings agencies:  

Think back to my analogy of the buckets and the rain. Sometimes, a ratings agency would look at a CDO and say, “You’re never going to fill up these buckets all the way. Those final tranches—the ones that won’t get filled—they’re really risky. So we’re going to give them a bad grade.”  There were “Dog Shit” tranches, and Dog Shit gets a bad grade.

But then the CDO managers would go back to their offices and cut off the top of the buckets. And they’d do this for all their CDOs—cutting off all the bucket-top rings from all the different CDO buckets. And then they’d super-glue the bucket-top rings together to create a field full of Frankenstein buckets, officially called a CDO squared. Because the Frankenstein buckets were originally part of other CDOs, the Frankenstein buckets could only start filling up once the original buckets (which now had the tops cut off) were filled. In other words, the CDO managers decided to concentrate all their Dog Shit in one place, and super glue it together.

A reasonable person would look at the Frankenstein Dog Shit field of buckets and say, “That’s turrible, Kenny.”

BUT THE RATINGS AGENCIES GAVE CDO-SQUAREDs HIGH GRADES!!! Oh I’m sorry, was I yelling?!

“It’s diversified,” they would claim, as if Poodle shit mixed with Labrador shit is better than pure Poodle shit.

Again, you tell me. Do the ratings agencies deserve blame?!  

Does the government deserve blame?

Yes and no.

For example, part of the Housing and Community Development Act of 1992 mandated that the government mortgage finance firms (Freddie Mac and Fannie Mae) purchase a certain number of sub-prime mortgages.

On its surface, this seems like a good thing: it’s giving money to potential home-buyers who wouldn’t otherwise qualify for a mortgage. It’s providing the American Dream.

But as we’ve already covered today, it does nobody any good to provide a bad mortgage to someone who can’t repay it. That’s what caused this whole calamity. Freddie and Fannie and HUD were pumping money into the machine, helping to enable it. Good intentions, but they weren’t paying attention to the unintended outcomes.

And what about the Securities & Exchange Commission (SEC), the watchdogs of Wall Street. Do they have a role to explain the Big Short? Shouldn’t they have been aware of the Big Banks, the CDOs, the ratings agencies?

Yes, they deserve blame too. They’re supposed to do things like ensure that Big Banks have enough money on hand to cover their risky bets. This is called proper “risk management,” and it was severely lacking. The SEC also had the power to dig into the CDOs and ferret out the fraudulent mortgages that were creating them. Why didn’t they do that?

Perhaps the issue is that the SEC was/is simply too close to Wall Street, similar to the ratings agencies getting advice from the big banks. Watchdogs shouldn’t get treats from those they’re watching. Or maybe it’s that the CDOs and credit default swaps were too hard for the SEC to understand.

Either way, the SEC doesn’t have a good excuse. If you’re in bed with the people you’re regulating, then you’re doing a bad job. If you’re rubber stamping things you don’t understand, then you’re doing a bad job.

Explain the Big Short, shortly

You’re about 2500 words into my “short summary.” But the important things to remember:

  • Financial acronyms suck.
  • Money flowed from the investors down to the mortgage lenders, and the risk flowed from the mortgage lenders up to the investors. In between, the big banks and CDOs acted as middle men and intermediaries.
  • When someone feels like their actions have no risk, or no consequences, they’ll behave poorly (big banks, mortgage lenders)
    When someone is given what seems like an amazing deal, they’ll take it (individual home owners).
  • CDOs are like empty buckets. Mortgage payments are like rain, filling the buckets. Investors buy tranches, or slices, across all the buckets. If mortgages fail, then the buckets might not fill up, and the investors won’t get their money back.
  • CDOs are intentionally complex. So complex, that not even the people grading them understood what was going on (ratings agencies).
  • Buying insurance on something your do not own is a behavior with potential for abuse (big banks)
  • Buying insurance on something for more than it’s worth is a behavior with potential for abuse (big banks). This is where most of the money in the financial crisis switched hands.

And with that, I’d like to announce the opening of the Best Interest CDO. Rather than invest in mortgages, I’ll be investing in race horses. Don’t ask my why, but the current top stallion is named ‘Dog Shit.’ He’ll take Wall Street by storm.

Thank you for reading! If you enjoyed this article, join 6000+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week.

-Jesse

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Source: bestinterest.blog