Fixed Rate v. Adjustable Rate Mortgage
I’ve had several clients recently ask me about Adjustable Rate Mortgages. This is for those who are considering mortgages on homes. Let me start by quoting one of the greatest businessmen and thinkers of all time, the great John Malone:
“The cable industry created so many rich guys. It was the combination of tax-sheltered cash-flow growth that was, in effect, growing faster than the interest rate under which you could borrow money.” “Inflation lets you raise your rates and devalue your liabilities.”
Interest rates are at an all time low. They will rise over time. Inflation currently is at 2.8% annually. Every year you hold a fixed rate mortgage the liability gets devalued 2.8% while the value of the property should increase at least by the rate of inflation. This is a 5.6% annual increase in wealth annually. You might say, ” but I have to pay higher interest payments?”. The current spread between a fixed rate mortgage and a adjustable rate mortgage(7/1 ARM) is approximately .8% but the government is going to help subsidize this by giving you an interest deduction. In the highest tax bracket this reduces the after tax rate by 45%. The after tax difference is (3.8%-45%)-(3.0%-45%)=2.09%-1.65%=.54%(assumes the first couple of years is mainly interest). On a $750K mortgage this amounts to $4,050 annually in the first seven years.
Now let’s model this over time. If interest rates stay the same after year 7 and the reset on the ARM doesn’t change for the next 23 years then a bet to do an ARM works in your favor. This is highly unlikely; worse you have no hedge against rising inflation and therefore interest rates. Let’s say the ARM resets .25% a year after year 7, to a maximum of 6% (which is highly likely). Even though you pay more interest in the first 7 years with the fixed rate option, you still pay $565,000 in interest on the ARM over the 30 year life of the loan. You will pay $508,000 in interest over the life of the fixed rate mortgage. The break-even for the ARM adjustment is approximately 4.7%. Meaning that both loans will cost you $508K in interest over 30 years if the ARM after 7 years doesn’t adjust any higher than 4.7%.
The fixed rate is the better option because it is likely less expensive. Additionally, the fixed rate mortgage gives you a hedge against rates rising higher than the 6% that is modeled above. There are very few fee lunches in financial planning. The low rate fixed rate mortgages that are available today is a free lunch.
Why do retail investors waste their money trying to beat the market by investing in high cost managed mutual funds or broker provided portfolio managed funds? The average cost of a managed equity mutual fund is 1.49% and wrap account arrangements from brokerage managed funds is in the range 1.5% to 3% of assets under management (AUM). Vanguard provides a variety of indexed mutual funds and ETF’s for .06% to .30% of asset value. Does the difference in the cost (expense ratio) matter??
I recently attracted a 62 year old client who had a brokerage account worth $1M being managed by a large brokerage firm under a wrap account arrangement. The brokerage was charging this person 1.5% or $15,000 a year to manage the money. My client was frustrated because the domestic equities were not returning as much as the S&P 500 index and the bonds were underperforming the applicable bond market index ((Barclays Bond Index) while taking the same amount of market risk. We moved his account to a discount brokerage and changed his investments to low cost, tax efficient index funds with an asset allocation more suited to the client’s personal risk tolerance and life situation. The client now has better peace of mind, better index tracking and is paying less than ½ the investment management fee that he was paying at “big brokerage”. Saving $7,500 a year over 25 years at a return rate of 6% is $411,484 of extra money for retirement. Yes, it does matter, significantly!
Aust Financial Advisory (AFA) believes in the efficient market theory of investing. This means that the developed world stock markets efficiently process information and immediately reflect the prices of new information immediately in each individual stock. The implication is that the market prices of companies are immediately priced into the stock price so it is futile to stock pick or to try to beat the market. As matter of fact, Nobel winning academic research and studies has shown that over 10 to 20 years, 67% of managed mutual funds do not perform as well as their performance market index benchmarks. These same studies have shown that the cost of investing is the major determinate of fund performance. The conclusion to this vast amount of research is that low cost, diversified market index investing has the highest probability of achieving individual financial goal targets.
An intelligently constructed individual portfolio should consider the following criteria:
- Time- Time is the most important factor in determining the make-up of the assets in the construction of a portfolio. When will the money in the portfolio be needed for a financial goal?
- Occupation- Are you employed by a business that is highly cyclical such as real estate or one that is more resilient against market cycles like the heath care business.
- Risk Tolerance- “Are you a Stock or a Bond” What is your personal tolerance for risk. When markets are rising, people tend to not concern themselves with risk, it is when markets contract, like in 2001 & 2008, when we are confronted with our aversion to risk. Stocks are approximately 4 times more volatile or risky than Bonds.
- Expected Returns- What are the returns that you require to meet you financial goals in the future. The 6 month U.S. Treasury Bill rate, which is currently yielding .14% annually, is the baseline for a risk free asset. If we need a higher expected return we must invest in riskier assets to get to our financial goal number. Over the last 75 years, Bonds have yielded 5.6% and stocks, a volatile/risky asset class, has returned on average about 9%. Your expected return and the other factors will help determine our asset mix. Never take risk you do not need to take.
- Asset Class Preference- Based on all of the other criteria, we determine the asset class preference for the portfolio. It is prudent to only take risk for which we need to take and will be compensated for taking. If a client already has all of the money they need to fund a comfortable retirement over their expected life span, it would be imprudent to have a portfolio that is equity/stock heavy (riskier). This is taking risk that the client doesn’t need to take.
- Tax Status- AFA uses Electronic Traded Funds (ETF) and low cost mutual funds to construct portfolios for our clients. We look for funds that have low portfolio turnover and operate tax efficiently. Additionally we optimize asset location to optimize the tax treatment of your different account types. Tax deferred accounts such as IRA and 401K account should hold assets that generate ordinary income distributions and taxable accounts should hold more tax efficient equity funds that generate foreign and domestic qualified dividend income.
To construct a proper investment portfolio it is imperative for us to know our clients well. AFA portfolios are low cost, risk appropriate, tax efficient and appropriately diversified based on your individual criteria. We recommend you have us construct your portfolio and monitor and rebalance it over time. As a holder of the Accredited Investment Fiduciary® (AIF®) we us the FI360 methodology suggested for prudent investment fiduciaries for constructing and monitoring our client portfolios.
A client recently asked me to investigate the best vehicle to use for she and her family to use to contribute and save for the college education of her grandson. Since AFA is a fee-only financial planner, I looked at the vehicles that are offered through a variety of sources, discount brokers, mutual funds, as well as those that are marketed directly from individual states. I quickly found that the best plans are provided and marketed directly from state governments. Specially, the plans from Nevada, Ohio, Virginia and Georgia caught my interest. These plans are all very low cost, have a great diversity of investment choices and some offer state tax deductions for contributions made by residents of their state. These plans are not available to be sold by brokerage firms, so if you ask your local “Big Company Brokerage” stockbroker for a recommendation, typically, they will sell you their brokerage sponsored 529 and not even mention the state direct marketed plans.
529 plans allows parents, grandparent, or other family members to open and own an account for a beneficiary, normally a child or grandchild. An individual may make five years of annual gift tax exclusion gifts up front ( $13,000 X 5=) $65,000 to a 529 account; for joint filers this amount is ($26,000 X 5=) $130,000. This will reduce the individuals total estate for estate tax purposes. The earnings of a 529 account are never taxed as long as the money is used to pay for qualified expenses for post secondary school (higher) education. Funds can be used for tuition, mandatory fees, books, supplies, and equipment required for enrollment or attendance; certain room and board costs, certain expenses for “special needs” students. Whether a beneficiary decides to go to a private or public college or university, in-state or out-of-state, trade or graduate school, funds in the account may be used at any eligible higher educational institution in the nation and many abroad. The beneficiary can be changed at any time to a relative, even a first cousin, of the original beneficiary. The account owner always owns and has control over the funds in the account. A contingent owner may be named so in the event of death or incapacity of the original owner, the account does not have to pass through the probate court process. This is a wonderful, low cost way of saving money for a loved ones higher education.
The Georgia plan is managed and operated by TIAA-CREF My recommendation for Georgia residents is to enroll in the state sponsored and marketed Georgia Path2College 529 for several reasons listed below:
- Georgia provides up to a $2,000 state tax deduction for contributions to the plan for each taxpayer who contributes. This could save a taxpayer $120 annually in Georgia state tax.
- The investment choices offered by TIAA-CREF are broad, robust, low maintenance and low cost. The age based options are allow you to choose an age band for the age of your child and TIAA-CREF will change the portfolio allocation, from more aggressive to more conservative, automatically as the child gets older and moves toward college age, normally 18.
- The plan and investment choices are very cost effective and range between 0.29%-0.40% annually for assets under management. This compares favorable to broker provided plans that average over 1%.
- There is no annual maintenance fee for maintaining the account. Brokerage firms typically charge $50 to $100 annually to maintain an account.
- Low contribution minimum. You can open an account for as little as $25.00 and subsequent contributions of $25 or more can be made at any time.
If you live in Georgia, certainly give the Georgia plan a hard look. You can go to the Georgia Path2College website, read the disclosure booklet to learn more about the plan. If you choose, you can very easily open an account on-line. The customer service phone line is fantastically responsive and the customer service reps are very knowledgeable. I believe this is a very good choice for an individual who is a Georgia resident wants to open a 529 for a loved one. If you have any questions about a 529 or any other financial question you can contact me to discuss.
Comprehensive, Fee-Only, Financial Planner Cost Justification
Comprehensive, Fee-Only, Financial Planners are some of the the most highly trained and knowledgeable professionals in the financial planning business. They provide advice in the six major financial areas that affect people’s daily lives. These planners must have the skill, knowledge and experience to understand how changes in one financial area effect decisions in the other disciplines. Many of these planners are members of National Association of Personal Financial Advisors (NAPFA). This is an industry association that requires all of their members to provide comprehensive financial planning, sell no products of any kind, and to refuse referrals fees or monies for revenue sharing or soft dollar arrangements. NAPFA members can only receive payment for fees charged their clients directly for the advice they provide. These requirements are designed to make member financial planners objective, transparent, and devoid of conflict of interest. NAPFA has the most rigorous criteria required of financial planners to qualify to become a member. These are the criteria:
- CERTIFIED FINANCIAL PLANNER™
- Submit a comprehensive financial plan for peer review
- Complete 3 years of comprehensive financial planning experience
- Provides comprehensive financial planning services
- Fee-only compensation
- Abide by NAPFA’s Code of Ethics
- Complete 60 hours of continuing education credits, with specific
- requirements for 6 core competency areas (per 2 year cycle)
CERTIFIED FINANCIAL PLANNER™
- Pass a 5 course educational program to be eligible to sit for the CFP® exam
- Pass a 2 day exam, which has a pass rate of ~57%
- Complete 3 years of financial planning experience
- Abide by the CFP Board’s Code of Ethics
- Complete 30 hours of continuing education credits (per 2 year cycle)
It is clear that these Financial Planners are unbelievably educated, trained, ethically conderned, and qualified. The question I want to address in this post is: are they worth the $185-$200 an hour they charge for their services?
Let’s put these fees in the context of other professions and then discuss the hard and soft dollar benefits of financial planning to determine if the value eclipses the cost of professional, fee only, financial planning. Let’s take a brief look at the cost and value of a few of other professions that individuals typically hire to provide services:
- Auto Repair Mechanic- Whether you use a dealership or a local, individually owned repair shop, you will pay $95-$110+ an hour for labor to get your car repaired. In addition, you will pay for the parts, lubricants and liquids needed to complete the job. The owner makes a good profit selling replacement parts. Some repair shops charge flat hourly rates for a standard repair job.. Example: Standard time to perform a brake job is 6 hours when it actually takes them 4 hours. You get charged for 6 hours. You are spending a lot of money to keep a depreciating asset working. Value: Being able to get to work etc. Necessity- little quantifiable return on money spent.
- Plumber- The hourly rate depends on the urgency of the situation. If you need a plumber in an emergency or can wait to be scheduled. The hourly charges on average ranges from $125-$200 an hour with typically a 2-3 hour minimum. They also sell products and parts such as hot water heaters or valves, etc. Value: Fix an emergency problem or an annoying leaky toilet or faucet. Necessity- little quantifiable return on money spent.
- Stockbroker, Insurance agent- If you have a broker or insurance agent, you are paying them commissions or fees through the Management Expense Ratio (MER) fees that either the mutual funds companies or the brokerage take directly out of your funds. On average, this is approximately 1.5% of invested assets annually. Insurance agents get paid commissions from the premiums that you pay. Value: Depends. Read my blog on passive investing. If your broker thinks he can beat the market, he is either ignorant or disingenuous, many academic studies over the years have dispelled the myth that investors or active portfolio managers can consistently beat benchmark market indexes. This is a needlessly expensive, unproductive way to invest for retail investors.
- Lawn Care Service- I find that many people spend a significant amount of money on lawn care. I estimate that they spend $70-$100 an hour for this service. Value: Beautiful lawn. Necessity- little quantifiable return on money spent.
- Accountant/CPA- National average $220 an hour. Value: Lower taxes, representation before the IRS if needed, other. Could be significant.
- Lawyer- $250-$500 an hour. Value: Representation before the courts and laws. Dependent on the issue addressed. Could be significant.
What are the benefits value of hiring a Comprehensive Fee-Only Financial Planner? Should every family make financial planning fees an important part of their annual budget? I will break down the benefits in each of the six financial disciplines that planners typically address. Below is a only a partial list of value and benefits that some clients have realized from comprehensive financial planning and are not applicable to every client. Every individual has a different financial situation and these benefits listed below may or may not apply to your individual circumstances. I would be glad to meet with you in a complementary initial meeting to better determine the value of Financial Planning in your situation.
These are a sample list of value and benefits that is possible to identify and derive from Financial Planning and execution:
- Cash Flow Analysis- What are necessary expenses and what are discretionary expenses that might be underutilized and reduced or eliminated? A financial planner can compare expenses, benchmark them against the market and determine if they are reasonable. Examples are cable television, insurance payments, lawn care services, cell phone bills etc. Reducing cost on any monthly recurring expense has a multiplier effect (12X) on the annual cost. Saving $200 a month in expenses has a big impact over time. If you save $200 a month and invest the savings for 25 years at 6% you would accumulate another $138,599 at the end of the time period before taxes.
- Debts and Assets- Understanding you debts, interest payments, recommended ratios for debt to income and your overall Net Worth allows a client to focus their cash flow on those areas that have the largest impact for reducing cost. Reducing high interest debt, student loan debt and understanding the effect interest payments have on your expenses can allow a clients along with a financial planner to structure a proper debt reduction strategy. If a client has $20,000 in 19% credit card debt, they pay a minimum payment of $100 a month for one year they will owe $22,838 at the end of one year. Putting together a successful plan to pay this debt down over two- three years could save this client approximately $60,000 to $75,000 in interest payments over ten years. Sound advice concerning a client’s mortgage choice can save huge amounts of money especially if we have rising interest rates and inflation in the future. If these conditions materialize, the proper mortgage choice could save a client tens of thousands of dollars in interest payments.
- Investments- Read my blog post on Passive Investing for a full explanation. If you have investments with a broker or an insurance agent, this is low hanging fruit for a client to save money. Brokerages and mutual fund companies on average charge approximately 1.5% in Management Expense Ratio (MER) or fees charged directly against investor funds. AFA provides two services to help clients manage their investment portfolios that can save a client significant amounts of money annually. If you have $500K in investable assets in your 401K and taxable accounts, AFA would charge $3,500 annually to provide you our Investment Mentoring Service. We actively monitor the portfolio and meet with clients either quarterly or semi-annually to discuss the portfolio, performance and rebalance the investments. The savings over the average broker managed portfolio is $4,000 annually ($7,500 broker fee- $3,500 AFA Investment Mentoring Service= $4000).
- Insurance Risk Management- Again this is low hanging fruit for cost savings. A Fee-Only Financial Planner can review all of your insurance policies and assess your overall risk. Aside from the soft cost of properly hedging and mitigating your risk, cost savings can be achieved by understanding these risk and only paying for insurance to mitigate risk that can’t be self funded. For instance, as you get closer to retirement and your retirement money accumulation target, the less life insurance you might need. A strategy to reduce the death benefit of life insurance policies as you get closer to retirement can reduce life insurance premiums. Auto insurance premiums vary widely from company and family circumstances. Recently a client saved $800 a year because one insurance company had lower rates for teen drivers than the client’s current company. I have seen client’s save 15-25% of their insurance premiums by having a planner evaluate and make effective recommendations.
- Retirement Planning- When do you want to retire, how do you envision your life in retirement, what changes do I need to make between now and then to achieve my goal. Knowing what part of your financial life needs to change and having the retirement goal as your motivation, will give you clarity about what is important to you in the present. The benefit of a retirement plan is clarity and commitment. What are you willing to forgo in the present to be able to fulfill your dream and goal of retirement. This will be motivation to find hard dollar savings to fund the achievement of the retirement goal.
- Tax Planning- Most CPA’s do a wonderful job of gathering your tax data and efficiently filing your income tax return. Most people do not have a professional who is pro-actively looking after their tax situation and making recommendations concerning strategies for reducing their income tax liability. A Comprehensive, Fee-Only Financial Planner makes recommendations that can reduce or defer taxes paid to the US and state governments. Investments should be held in the most tax efficient accounts. Any investment instrument that generates ordinary income, like bonds, are best held in a tax deferred account like an IRA or 401K. A well time Roth IRA conversion can save the client thousands of dollars in income taxes. E.g. If you started a business and had a Net Operating Loss in the tax year, this is a good time to perform a no or low income tax conversion to a Roth. Once the money is in a Roth it is never taxed again and doesn’t have a Required Minimum Distributions at 70 ½ years of age like a Traditional IRA.
- Estate Planning– A Financial Planner does not practice law but can help develop the best financial plan for a clients estate based on a client’s desires for the distribution of their assets when they pass from this world. Transferring assets from one individual or entity to others is a tricky difficult problem as individual state laws and federal tax law have jurisdiction over this process. Plans should be made in advance of a person’s death because if they aren’t state laws and local probate judges will determine many important decisions concerning your assets and responsibilities. In Georgia, if you die without a will or intestate, one third 1/3 of the estate goes to the wife and two thirds 2/3 goes to the children. If you have a child who is a minor a probate judge will appoint a guardian. With a will you can determine this in advance. If you have a large estate and younger children inherit a large sum of money, will they have the maturity to handle it in the way you would wish? If you die and your wife remarries a young stud muffin, will your children ever see any of your money as you might wish? You might want to consider a trust (QTIP) that handles your money the way you want. Estate planning can save loads of money from misappropriation.
A comprehensive financial plan and the resulting recommendations, executed properly can have a large, positive hard dollar impact on the life of the client. It is my belief that an good financial plan updates annually is essential for every person and family. In the examples I have shared in this post, I have given concrete hard dollar examples of how you can benefit from hiring a Comprehensive Fee-Only Financial Planner. A comprehensive plan cost between $2,100 and $5,000 depending upon your individual financial complexity. At AFA we derive this range of prices from how many consulting hours we estimate to complete the plan. Our experience has been that a well analyzed, customized, and constructed comprehensive plan generally takes between 12 and 27 hour to complete. This will be the best money you have or ever will spend to get not only a financial blueprint and roadmap for the future, but concretely developed, financial goals and tangible, significant cost savings in the short term. Call Aust Financial Advisory immediately to schedule a meeting to discuss your situation, and determine what value you can unlock from engaging us in developing for you a Comprehensive Financial Plan.