I am remortgaging a home for a client and we decided that it may be better for her to escrow her real estate tax payment with the lender. 

This is a new arrangement for her; she currently pays her tax bill from her bank account.

In reviewing the new loan's numbers, she noticed that we were setting four months worth of taxes aside to populate her new escrow account. 

Her first installment of Cook County taxes are due March 1 and her question followed:

How did the lender decide how much money I have to set aside for taxes?  Why do I need to bring four months for taxes if I just paid them?

I can't speak definitively for other locales, but in Cook and the Collar Counties, taxes are paid semi-annually.  The two dates of payment vary by county, but either way, the real estate tax liability is split into two parts.

In Cook County, for example, tax bills are due March 1 and September 1.

To take a step back, we should briefly address: "What does it mean to pay taxes in escrow?" 

Paying your taxes in escrow means that your lender agrees to handle your real estate tax payments for you, and that you agree to set aside money each month with your lender so your lender has the funds to make those payments.

Each month, a mortgage payment for escrowing homeowners is comprised of the actual mortgage payment plus an additional payment of 1/12 of the year's tax bill into an escrow/reserve account.

Because funds are already on deposit, when the tax bill comes due, the lender makes the payment on behalf of the homeowner from its reserve account.

Okay, now we know how escrow works.  Let's get back to the question.  If the tax bill was just paid, why does the lender need four months of reserves on hold. 

As my client was asking, wouldn't collecting four that mean that six months from now, the lender will have way too much money in the escrow account?  Like, 10 months?

The answer is "sort of".  And for the lender, it works out like that absolutely on purpose.

See, real estate tax bills tend to increase over time and the lender is usually the last to find out that a tax bill went up.  This is because when a homeowner's tax bill increases, the taxing body will send a letter to the home and not to the lender.  Rarely does the homeowner notify the lender about it.

Lenders know this.  And, they also know that they never want to be caught short-handed when it's time to pay a client's real estate tax bill.  They'll pay the bill either way because they are contractually obligated to do so, but they'd much rather do it with your money than with their's.

To make sure that it's your money paying your bill as often as possible, lenders will usually ask that you maintain two more months in reserve than are technically necessary to pay the tax bill. 

That way, so long as the taxes don't increase by more than 16.67% annually, the lender will never have to go out-of-pocket to cover your homeowner's liability. 

That brings our "10 month reserve" down to eight months.  Now, let's tackle how we go from eight to six.

My client is closing her loan in mid-March which means that her first mortgage payment will not be payable to the lender until May 1. 

At her closing, she will pay mortgage interest for March, but no principal and no tax proration.  In addition, she will not make a mortgage payment at all in April.  Therefore, there is no 1/12 tax payment being made in March or in April.  These two months are the make up the difference between eight and six!

So, even though my client just paid her March 1 tax bill this week, she will need to populate her escrow account at closing with four months of reserves to make the lender happy:

• 1 month for the "missing" March payment
• 1 month for the "skipped" April payment
• 2 months for the escrow "cushion"

By the time she starts paying her mortgage in May, she will be right on track to have eight months in the escrow account come September 1 -- just like the lender wants.

Could the title of this post be any longer?

Matt in Manhattan sent this question via email.  I thought I'd share the conversation because it makes for good learning. 

The question (edited for length and clarity):

The payment on a 30-year fixed mortgage for $1,000,000 is $6,418.  The same payment on a 5-year ARM with the interest only option is $5,428, or about $1,000 less per month.

Other than the risk that my ARM will adjust higher in the future, is anything lost by taking the 5-year ARM with interest only and paying an extra $1,000 every month to reduce principal?

In which scenario will I have more equity in 5 years?

This is a terrific question with many angles to it.  For purposes of answering the question, though, I want to focus on the math. 

Focusing on math forces me to ignore basic mortgage planning concepts that would preclude me from ever having this conversation with a client.  But, because Matt asked, I am sure that other readers are interested in the actual answer to the question, too.

For Kurt, Brian, Russell and others that will comment about the plan being foolish to begin with, please consider the following bullet points my own personal disclaimer.  This is a purely mathematical discussion and is irrelevant with respect to sound financial planning because I am unilaterally believe:

• Interest only loans increase cash flow for safe investments; home equity is not a safe investment.
• Home equity does not earn a rate of return.
• Dollars placed in a safe, liquid account will earn compounded interest over time and, therefore, have higher utility than dollars used to pay down a mortgage.

Disclaimers done.

Now, I especially like this question because the reader lives in Manhattan where properties are super expensive versus the rest of the nation.  Matt's figures are nice, large numbers and that helps to exaggerate our conclusions.  I like that.

Oh, and how expensive is "super expensive"?  Try $950 per square foot.  Noah can tell you all about it. 

Back to the question.  Matt asked, "Which plan creates more equity?"  The answer is that it's a tie.  Both plans create exactly zero dollars worth of equity.  How can that be?  Because there are two ways to increase the amount of equity in a home.

1. Pay down the principal balance on the mortgage.  This increases the difference between what is owed on the home and what the home is worth.
2. Let the home's value increase over time.  This increases the difference between what is owed on the home and what the home is worth.

Both methods increase home equity positions and, because of that, homeowners often confuse and mischaracterize the two. Let's delve deeper.

In Method #1, the homeowner takes dollars from a paycheck that have already been taxed and places them "on deposit" with the home.

In Method #2, the home itself creates value when the market appreciates.

The differences are subtle, but important. 

Method #1 depletes the homeowner's personal funds to "create" equity in a zero sum game -- the gain in equity is 100% offset by a loss in savings.  Method #2, by contrast, creates equity using no personal funds at all.

As the Manhattan condo market appreciates, Matt will gain equity because his home will be worth more on the open market (he hopes!).  Any dollars that he puts towards his mortgage, though, will come from his bank account. 

In that sense, Matt is playing a shell game with his own money, taking funds from one account (the bank) and placing them into another (the home).  The main difference here is that Matt can use an ATM and withdraw his money any time he wants; he can only get the money out from his home if he uses a remortgage, or if he sells.  ATM fees are much lower than remortgage fees.

Oops.  I am hitting my bullet points again about why I would never recommend this strategy.  Back to the math part of the question.  Sorry. 

According to Matt, he has two offers:

• The 30-year fixed mortgage is 6.625% for a payment of $6,403
• The 5-year ARM interest only is 6.500% for a payment of $5,417

Comparing the two plans, Matt's savings in Month 1 is $986.  He wants to invest that into his mortgage to reduce his loan balance.  Because the mortgage has an interest only feature, an interesting thing will happen. 

In Month 2, Matt's mortgage will drop by $5 to $5,411. 

The payment drops because interest only loans only require that interest to be paid on the existing loan balance. 

As the loan balance decreases (Step 1), therefore, so does the monthly payment (Step 2).

Step 1: $1,000,000 - $986 = $999,014
Step 2: $999,014 * 0.065 annual rate / 12 months = $5,411.32

In order to adjust for the change, Matt must increase his principal paydown in Month 2 to $991 from $986.

In Month 3, Matt must increase his paydown again by $5 to $996.  This pattern continues each month until the 60th month when we see that Matt is now investing an extra $1,355 monthly into his mortgage. 

The spreadsheet shows that after five years, Matt will have paid the exact same amount to his mortgage servicer regardless of which plan he followed -- $384,186.58.

However, if Matt had used the 30-year fixed mortgage, his remaining loan balance after 5 years would be $937,445 (and that's not shown above).  Using the 5-year ARM with interest only and "invest the difference", Matt's loan balance is $930,284. 

Choosing the 5-year ARM with interest only saves Matt $7,161 so clearly this is the winning play mathematically.

We should have known this from the start, though, right?  The 5-year ARM carries an interest rate that is 0.125% lower than the 30-year fixed mortgage so -- all things equal -- we should expect a lower carrying cost over 5 years.  Not surprisingly, the $7,161 represents the exact amount of additional interest from taking the 0.125 percent higher rate.

Our conclusion, therefore, is that there is no mathematical benefit to choosing an amortizing loan versus an interest only program and applying the difference toward principal.  The lowest cost option will be the one with the lowest interest rate.

Thanks, Matt, for the great discussion.

John posted a comment on Thursday's post, Like A Locomotive, Mortgage Rate Increases Are Picking Up Steam.   

"I am thinking of refinancing but do not want to be rushed into anything? Are rates going to rise that quickly? Who would you recommend I sign a mortgage with that you would trust?"

This is a very timely comment so my reply will be this post.  Thanks, John, for the terrific question.

The absolute bloodbath that occurred in mortgage rates today is one that we see maybe once per year, if that.  There was a turn in sentiment that was amazingly sudden and mortgage rates got murdered along the way.  We knew it could have happened, but today was really something else.

By the time the dust settled, mortgage rates were off by 0.25% across the board.  It was seriously brutal.

The worst part about it was that I spent most of the day on the phone with my new clients trying to explain the urgency of the situation.  Even though each was referred to me from a trusted source like a client or a real estate agent, none know me well enough to know my style.

I can only imagine what I sounded like to them:

"Look, mortgage rates are running higher and they're gathering steam.  You need to lock your right now because if you don't, you will pay a higher rate.  And I'm not even talking about if you lock tomorrow.  You're going to pay it an hour from now."

Sounds like Boiler Room, right?  Well, when it's an urgent message, I don't how else to get my message across. 

I also tried email reminders about the market and then stopped just short of sending the Pony Express to their places of work.

From my vantage point, I am presenting facts and I am the one in the relationship with the live bond feed coming across my desktop. 

It's my responsibility to make sure that the client hears the news that I intend to deliver.

Now, the clients that have worked with me before and who know how I operate?  They all locked in before the real damage was done.  Each of them got their rates while the going was still (relatively) good.

The clients with whom this is our first dance?  Not one of them. 

I watched their dollars just float away while they looked at me as if I were a high-pressure salesperson.  It's really a shame.  I don't know how else to say "YOU'RE MAKING A BAD DECISION BY WAITING" other than to just say it.

Can I blame the first-timers for not trusting me?  It really does sound "high-pressure" -- regardless of the trust that we may have already built together.  Sad, but true.

One client in particular that didn't respond to my calls or emails no longer qualifies for the home that he is under contract to buy; his debt ratios were so precariously tight.  Now, he'll have to pay points to lower his interest rate so he can get approved.  That will cost about $3,500.

So, John says he doesn't want to get rushed into anything and that is understandable.  Nobody likes to be rushed to make decisions -- especially ones that deal with hundreds of thousands of dollars in debt. 

But, today was a day, though, in which "not rushing into anything" was very costly for a lot of people.  I am not going to ask for comments, but I am sure that every loan officer reading this post will have at least one similar story from today.

On days like this, John, you just need to know that you're working with a Trusted Advisor and you have to be confident in their willingness to look after you.  As for finding an advisor you can trust, ask around in your circle of friends, family and co-workers for somebody who fits the bill.

Ted (originally) from Chicago asks:

Great blog. As a former Chicagoian, I enjoy the Windy City perspective. As somone [sic] in the market, I appreciate the perspective. That said, do you ever recommend waiting vs. buying? I understand the logic of your arguments...and the bias.

And my thoughts on the issue:

Yes, I recommend waiting to purchase, although not very often. 

When I do recommend waiting to purchase, it's never related to a market condition (i.e. seller's market, low rates, etc.) but to a personal finance condition.

See, a person that plans for the future financially -- and even one who intends to plan for the future -- needs to be living within their own means today.  If a potential homebuyer is not on stable ground and/or disciplined with their dollars, he can cause way more harm than good to himself in the long run.

The cardinal rule?  Never, ever miss a mortgage payment.  No matter what.  If you're unsure of if can fulfill your primary obligation to your mortgage lender, you shouldn't buy the house.

This is one of the reasons why I am adamant about having a reserve fund -- even at the expense of a downpayment.  After all, the downpayment won't pay your mortgage if you employer furloughs your entire department, or if you take sick leave for an extended period of time.

Waiting to purchase a home because of market conditons is no different that trying to predict the future of IBM's stock price, or the White Sox.  Sure, everything looks good on paper, but unexpected events happen and that can have dramatic impact on the future. 

Personally, I don't like to gamble like that -- I am a bird-in-hand guy.  But, like I said, it's a personal preference.

Thanks, Ted, for the question.  Glad to know your cynical enough to know that I am biased.