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The Trick to Overcoming Payment Myopia

by Jack Guttentag
Friday, March 12, 2010

We tend to undervalue the future. Nowhere is this tendency stronger than in finance, and nowhere in

finance is it stronger than in the mortgage market. Borrowers focus on the monthly payment because

that is today’s problem, to the neglect of how much they owe and the future obligations they may face

because those are tomorrow’s problems. I have termed this “payment myopia.”

The system encourages payment myopia. Like all sales people, loan officers and

mortgage brokers sell an alluring present, not a  challenging future. Lenders have created

instruments that support their efforts by offering reduced payments in the early years at the

cost of higher payments and larger balances in later years. The most radical of these was the so-called

option ARM (adjustable-rate mortgage), which allowed borrowers to make payments that did not cover the interest for

five -- and in some cases 10 -- years before the hammer fell. Since the crisis erupted in 2007, the default rate on

option ARMs has been so horrendous that they are no longer being written. 

But payment myopia continues. Today the instrument that most appeals to the payment myopic is the

interest-only (IO) mortgage. On IOs, the borrower pays only interest in the early years, usually for 10 years.

All adjustable-rate mortgages have an IO version, as does the 30-year fixed-rate mortgage.

There are some defensible reasons for selecting an IO, which I discussed in a recent article, but

most borrowers who take them do it for the lower payment in the early years, to the neglect of the future. That’s why I don’t like IOs.

Undervaluing the Future

Recently I have begun to think about possible ways to overcome payment myopia, other than

preaching, which I know from personal experience doesn’t work. I was provoked by a recent discovery of a

method of inducing more employees to sign up for retirement plans offered by their employers. That a large

proportion did not take advantage of plans that were highly advantageous to them was another

manifestation of the general tendency to undervalue the future. Underfunding retirement plans

and payment myopia have the same roots in the human psyche. It was discovered that if new employees,

instead of being offered an opportunity to join the retirement plan, were automatically entered

and given an opportunity to opt out, the participation rate increased dramatically.  Is there a

comparable technique, I wondered, that might induce mortgage borrowers to give greater weight to the

future in their mortgage decisions? Part of the reason why borrowers discount the future so heavily in making

mortgage decisions is that the future is not as clearly seen as it could be. As a general rule, the right type of

mortgage for John Doe is the one with the lowest total cost for Doe. The total cost is

a borrower-specific number, because it depends on how long the borrower expects to have the mortgage,

his investment rate, and his tax rate. Total cost is the sum of all monthly payments of principal and interest, points and other

settlement costs paid upfront, lost interest on monthly and upfront payments, less tax savings and balance reduction.

Knowing the Total Cost

But Doe does not know the total cost of the various mortgages he is offered because nobody

calculates it for him. He knows the starting mortgage payment very well because it is shown

on multiple documents. Hence, what should be a limiting condition -- the

starting payment must be affordable -- for all too many borrowers becomes the only thing they

look at in making a selection. Here is an illustration using an IO, which as I noted above has a strong appeal

to payment-myopic borrowers. On February 10, a prime borrower could have had a $300,000 30-year

FRM at 4.875 percent, or an IO version of the same loan at 5.5 percent. The

payment on the first was $1,587 and on the IO it was $1,375, a difference of $212 a month. Over 10 years,

that amounts to a saving of $25,516. In addition, assuming the borrower can earn 2 percent on his

money and is in the 27 percent tax bracket, the interest loss on payments is $1,939 smaller on the IO,

and the tax savings at 27 percent is $9,020 higher. This adds to a total of $36,475 in “saving”

on the IO. But, at the end of 10 years, the borrower will still owe $300,000 on the IO and only $243,101

on its fully amortizing counterpart, which is a balance reduction of $56,899. Bottom line, the total cost is

$20,424 larger on the IO. And let’s not forget that, in month 121, the payment on the IO jumps from $1,375 to $2,064, where it

remains for the next 20 years. The fruits of payment myopia are indeed bitter.

So how does a borrower who is determined not to be payment myopic find the total cost of different

mortgages? Don’t expect to get it from your loan provider. If you have all the necessary details about

the alternative mortgages, you can calculate the total cost to you of each mortgage using my

calculator 9ai on my Web site. Doing this could save you some serious cash.

Call for a quote 866-434-2483

or e-mail steve@walshfinancial.net

16b) Mortgage market news and information http://www.housingmatrix.com/index.php/mortgage-market/

• Currently all federal tax brackets will be hit:
  
  
  • The 10 percent bracket will rise to 15 percent
    
  • The 25 percent bracket will rise to 28 percent
    
  • The 28 percent bracket will rise to 31 percent
    
  • The 33 percent bracket will rise to 36 percent
    
  • The 35 percent bracket will rise to 39.6 percent
• Itemized deductions and personal exemptions will be phased out,
•  which is the same thing as raising taxes even higher than just the effect of the above bracket increases.
  
  
• The estate tax exemption will be $1 million, and the top bracket for the death tax will be 55 percent.
  
  
• Capital gains will rise from 15 percent to 20 percent .
  
  
• The dividend tax when stock is held for less than one year goes from 15 percent to 39.6 percent.
• This will then rise another 3.8 percent, to 43.4 percent in 2013.
  
  
• Obamacare will add over 20 new taxes, the first to go into effect on January 1.
  
  
• Health savings accounts will no longer be available, nor will flexible spending accounts or
• health reimbursement accounts.
  
  
• Typically, businesses expense their purchases of equipment to effectively reduce their
• income by the same amount to save on taxes. Not any longer. Now, we have to depreciate
• our equipment purchases, thus another tax increase.
  
  
• The Alternative Minimum Tax will ensnare a projected 28 million families, up from four million last year.
  
  
• Charitable giving from IRAs will no longer be allowed.

• About

THE BOTTOM LINE

Congress has passed laws, rules and regulations that encourage responsible retirement

planning by granting favorable

tax treatment to a wide variety of plans.

Retirement plans are defined by the IRS tax code and are regulated by the Department of

Labor’s ERISA provisions.

Safeguard Financial’s attorney consultants

are specifically trained in ERISA law.

ERISA ( Source: Wikipedia.com)

The Employee Retirement Income Security Act of 1974 (ERISA) (Pub.L. 93-406, 88

Stat. 829, enacted September 2, 1974)

is an American federal statute that establishes minimum standards for pension plans

in private industry and provides for extensive rules on the federal income

tax effects of transactions associated with employee benefit plans.

ERISA was enacted to protect the interests of employee benefit plan participants and

their beneficiaries by requiring the disclosure to them of financial and 

other information concerning the plan; by establishing standards of conduct for plan

fiduciaries; and by providing for appropriate  remedies and access to

the federal courts. ERISA is sometimes used to refer to the full body of laws regulating employee benefit

plans, which are found mainly in the Internal Revenue Code and

ERISA itself. Responsibility for the interpretation and enforcement of ERISA is divided

among the Department of Labor, the Department of the Treasury

(particularly the Internal Revenue Service), and the Pension Benefit Guaranty Corporation.

Prohibited Transactions

Defined in IRC 4975(c)(1) and IRS Publication 590, these rules were established to maintain

that everything the IRA engages in is for the exclusive benefit

of the retirement plan. Professionals often refer to these transactions” as “self-dealing” transactions.

This section of the code identifies prohibited transactions

to include any direct or indirect: • Selling, exchanging, or leasing, any property

between a plan and a disqualified person. For example, your IRA cannot

buy property you currently own from you. • Lending money or other extension of credit between a plan and

a disqualified person. For example, you cannot personally guarantee a loan for a real estate

purchase by your IRA. • Furnishing goods, services, or facilities between a plan and a disqualified person.

For example, you cannot use personal furniture to furnish your IRAs rental

property.• Transferring or using by or for the benefit of, a disqualified person the income or

assets of a plan. For example, your IRA cannot buy a vacation property you or

your family intends to use. • Dealing with income or assets of a plan by a disqualified person who is a fiduciary

acting in his own interest or for his own account. For example, you should

not loan money to your CPA. • Receiving any consideration for his or her personal account by a disqualified person

who is a fiduciary from any party dealing with the plan in connection with

a transaction involving the income or assets of the plan. For example, you cannot

pay yourself income from profits generated from your IRAs rental property.

Disqualified Persons

A disqualified person (IRC 4975(e) (2)) is defined as:

•The IRA owner
• The  IRA owner’s spouse
• Ancestors (Mom, Dad, Grandparents)
• Lineal Descendents (daughters, sons, grandchildren)
• Spouses of Lineal Descendents (son or daughter-in-law)
• Investment advisors
• Fiduciaries – those providing services to the plan
• Any business entity i.e., LLC, Corp, Trust or Partnership in which any of the disqualified

persons mentioned above

has a 50% or greater interest.