QUESTION: How would you rate the following mortgage arrangements, from best to least favorable? Assume that I am in a 50 percent tax bracket and that I will borrow $100,000. Borrowing from a bank at the bank's prime rate with interest floating as the prime changes. No points in this transaction. Borrowing from my children at an interest rate of about 15 percent. This would require legally drawn documents that satisfy Internal Revenue Service requirements. No points would be paid. Obtaining a conventional 15- to 30-year fixed mortgage at current rates and current points. Obtaining a floating-rate mortgage at current rates and points.ANSWER: I found your letter most intriguing. Perhaps the reason for my interest is that you have highlighted a very significant issue for real estate investors -- namely that there is a lot of creativity in the marketplace, if only we would look for it.
You have outlined a number of choices, and it really is not fair to rank these in order of priority. Each of us has different needs and different considerations. However, let me give you some observations on the various types of loans you have suggested.
The first proposal may not be available for mortgage financing. Most banks do not like to make long-term loans, and you may find that the best you can get is a 90-day (or perhaps six-month) rollover. This means, for example, that you will be borrowing $100,000 at a favorable interest rate, but that the loan will become due within the 90-day or six-month period. You certainly can't continue to roll this over each and every time period, but in my opinion, this kind of loan should be used only as an interim measure. If you are buying a house and have not yet sold your current house, this kind of arrangement makes sense as a bridge loan.
Your next proposal, namely borrowing money from your children, may be the best approach -- depending, of course, on a lot of facts. Can your children take the $100,000 that they have and invest it more wisely than by lending it to you? If your children have $100,000, perhaps they would be better off buying another piece of real estate, which would give them a greater rate of return, including some tax shelters. On the other hand, if your children are young and are not in a high tax bracket (although they are fortunate to have a large sum of cash), then it makes sense for them to lend that money to you. However, you have highlighted one very important factor, namely the IRS requirements. You are strongly advised to check out the validity and legality of any such loan from your children with your tax adviser.
Your final two proposals should be analyzed together. Basically, you're asking whether a conventional 15- to 30-year fixed rate is better than a floating-rate mortgage. My crystal ball cannot see beyond the election. I do not know how interest rates will be in the next few years, although I seriously doubt they will drop significantly.
If you are on a fixed income, and are concerned about variations and fluctuations in your monthly mortgage payments, then the fixed rate is probably best for you. Because you are in a 50 percent tax bracket, the 30-year fixed rate is more beneficial, in my opinion. The 30-year rate will cost you a lot more in interest, but the monthly mortgage payments will be lower than a 15-year rate. Additionally, you will obtain a significant tax savings by way of the mortgage interest deductions. And, in my opinion, most people do not hang onto their house for 30 or even 15 years, and thus the lower payment with a higher deduction makes sense to me.
On the other hand, if you do not intend to stay in the house for more than three or four years, then an adjustable-rate mortgage may be right for you. If the initial rate for the adjustable-rate mortgage is sufficiently lower than the the fixed rate, even with the maximum adjustment per year, over a three-year period the average monthly payment will be less or equal to a fixed rate.
Let me give an example: If the going interest rate on a fixed mortgage is 13 1/2 percent, an adjustable-rate mortgage that starts at 11 1/2 percent with a 2 percentage point yearly cap will average the same as the 13 1/2 percent fixed-rate mortgage over three years. In effect, the first-year rate will be 11 1/2 percent, the second 13 1/2 percent, and the third 15 1/2 percent. The average, of course, is 13 1/2 percent. The first year, you get tremendous savings because you are 2 percentage points below the market. The third year you are paying 2 percentage points above the market -- assuming the worst financial conditions.
Again, only you can decide what is right for you and under which arrangement you will be more comfortable.
All real estate consumers should look around carefully to determine what sources of money are available to assist in their real estate purchases.