The Wrong Loan

Posted: Apr 02, 2007 3:02 PM

After being in this business, the mortgage business, for over 18 years, I am now more convinced than ever that the majority of people take the wrong loan. Some are just overpaying because their interest rate is too high for their situation and others are simply in the wrong plan. The amazing part about it is that for the vast majority of people, this will be their biggest obligation in their financial life. And to make it even more ridiculous, most of the same people will have the right auto loan, the wrong insurance, little or no reserves for emergencies and decent jobs. What is missing is fairly evident: people do not get nor do they seek a good education when it comes to their finances.

Although I am not in the insurance business, it frustrates me that so many people have the wrong insurance. for most people, life insurance functions to replace the head of the household's income if he or she dies prematurely especially if the children of the family are still dependents. Some have used life insurance, in the past, to pay the inheritance taxes on the estates subject to inheritance taxes, but this is a small minority. Once the children are on their own why do you carry life insurance? And as you age up why don't you have disability insurance and long term care? If you need these types of insurance and you don't have them you could have a real problem.

This brings us to reserves. Why are they either less than they should be or completely non existent? You really need one year's income as reserves if you want to live comfortably and without excessive worry. If you can't get to that amount in a reasonable time then look to one years debt payments and get that into the bank.

Why don't people have the insurance and the reserves? They tell me that they can't afford it. These people who state that to me generally have sufficient equity in their house to cover their insurance and reserves but look at me as if I have told them to rob a bank when I suggest that you take it out of your house and buy the insurance and put the reserves in the best financial instrument you can. A savings account, a mutual fund, a bond fund or anything else you feel comfortable with that is liquid enough to be converted to cash in a week or two. If it is a safe deposit box and you are comfortable with it, so be it.

Why would you leave the money in the house, have disaster strike and put yourself in a position to lose the house? A number of clients were shocked to find out that if an earthquake, flood or fire occurs in the vicinity of your house , the banks will freeze your equity line of credit and that, of course, was their reserves.

Do I understand that a lot of people are reticent to do what I suggest? Absolutely. Do they understand that I have seen over the last two decades horrors that have happened to people who weren't sufficiently protected? Sometimes I do not think so.

Now what about the wrong loan that is supposedly the subject of this column. It is pretty simple: a 30 year fixed is not the universal answer to everyone 's situation. If you are going to move in 5 or 6 years because your kids will be out of the house and you are most anxious to move on , why not save 1/4% to 1/2% by taking a 5 year or 7 year arm which is fixed for the period of time you choose. The savings is $60 to $120 a month and if the money isn't significant then take the 5 or 7 year loan and pay it as if you had the 30 year fixed.Your balance will be lower at the time you decide to move by about $5,000 to $10,000.

When a borrower finds a decent rate or better than that a great rate why do they not take some time to decide if they will need additional monies down the road. I am besieged by borrowers who have 4% and 5% loans that they took out three or four years ago and now either want to combine their equity line which they took out subsequent to the low loan, or wish to take out additional money now. They basically have negated some of the savings of the good first mortgage by the much higher second mortgage. I do also realize that everyone didn't have the equity to take out more at that time.

Last but not least, people in California learned the hard way about taking a 30 year fixed instead of a 15 or 20 year fixed. In the early 90's when we hit the lowest rates, we had seen in 30 years we had a real estate slump. Everyone wanted to refinance but only those, for the most part, who had 15 year loans were able to because they were the only ones with equity in their house. Since that time, people have moved in large numbers to 15 year loans so they will not be caught again. This is a lesson that some in other parts of the country haven't learned but should as they see their houses depleted of their equity.

There is an awful lot to know about personal finance and you really need to take the time to learn it. If you don't, it could be hazardous to your wealth!