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Ep 10 – Investing and The Mortgage Market 

Metin Akyol, Ph. D., CFA

Data Scientist at Zack's Investment Management

Robert Scott

Senior Mortgage Advisor at Finance of America

Welcome to Season 1, Episode 10 of Meet the Expert® with Elliot Kallen! 

In this episode, Elliot is bringing on Robert Scott and Metin Akyol to discuss updates on the mortgage market and behavioral finance.

Metin Akyol, PhD., CFA, Data Scientist at Zacks Investment Management, sheds some light on the consequences of behavioral biases. 

Individuals don’t take a perfectly rational approach when making financial decisions. A lot of the time, this is due to the inherent biases that all individuals hold.

As a savvy investor, you need to understand what drives markets, what drives individuals, and why individuals act the way they do in order to understand the forces that move us in one direction versus another.

What does the average investor look like? The average investor works without a disciplined system, and allows emotions to drive investment decisions. Sometimes investors become overconfident and misjudge risks. Other times, they latch onto a price target or think they’ve identified a pattern that doesn’t actually exist. This causes a behavioral gap in your returns; there’s a huge gulf between what you have and what you could achieve. 

Unfortunately, this behavior gap can be catastrophic to retirement planning. 

When the market starts tumbling, many people hit their pain threshold and start to sell because they’re scared that this drop could turn into a death spiral. By failing to stay the course, an emotionally driven investor allows their pessimism to get in the way of better returns. However, understanding behavioral biases gives you a chance to overcome these economic outcomes.

By knowing that all individuals are subject to silent behavioral biases, we can adapt our behaviors and modify our processes to improve our investment outcomes. For example, let’s say that you have a tendency to hold onto poorly performing stocks because you don’t want to admit defeat. Understanding your own biases will motivate you to remove yourself from that process and its associated risks. You may benefit from working with an Investment Advisor who will take a more disciplined, data-driven approach.

Which biases should I be aware of?

Some common cognitive biases include:

  • Conservatism. How willing are you to accept new information about your stocks as it comes in? Do you revise your beliefs about an investment when presented with new information (particularly unpleasant information)? For instance, think of how you would react to a negative earnings report on a stock you previously considered to be a good investment.

  • Confirmation bias. Are you neutral when searching for and interpreting information about existing beliefs? Individuals tend to be biased when researching information on a topic based on their beliefs, and reconfirm information that we already know.

  • Status quo bias. Do you fail to explore new opportunities? This is especially important when a change could mean better portfolio returns.

  • Home bias. Do you find yourself investing only in familiar stocks? Do you have a preference for investing in stocks after spending a significant amount of time researching them?

It’s equally important to be mindful of emotional biases:

  • Loss aversion. We dislike losing significantly more than we enjoy winning.

  • Disposition effect. Investors will hold onto losers for too long and sell winners too soon.

So why is it so helpful to understand common cognitive and emotional biases?

Because market volatility has the potential to exacerbate these effects. 

Nobel Prize Laureate Richard H. Thaler studied the consequences of myopic loss aversion, the idea that the more we evaluate our portfolios, the higher our chance of seeing a loss and, thus, the more susceptible we are to loss aversion. Additional research shows that investors who get the most frequent feedback also take a less than optimal amount of risk and earn less money—regardless of their objectives or time horizon!

To illustrate, we can look at the costs of timing the market versus staying fully invested. Let’s say that you invested $10,000 into the S&P 500 from January 1, 1997 to December 31, 2016.

If you...

Percentage Return

Ending Value of $10,000

… stayed fully invested

7.68%

$43,933

… missed the 10 best days

4.00%

$21,925

… missed the 20 best days

1.57%

$13,662

... missed the 30 best days

-4.16%

$4,275

As you can imagine, missing out on the best days can happen very quickly when you engage in market timing. The market doesn’t give daily returns like an interest rate; rather, it gives massive pushes one day and massive pullbacks on another. The buy-and-hold strategy generally outperforms any type of in-and-out market timed approach.

How can I avoid the behavioral gap?

For one, focus on asset allocation and diversification. Diversifying your portfolio helps you accomplish two things at once: reducing risk and enhancing returns. 

Second, stay the course. Trying to time the market means increasing the probability that you won’t be invested on the big “up” days. And if the stock market history tells us anything, it’s that there are a lot of up days. 

Finally, find a manager with a long-term approach. A Fiduciary Wealth Manager can help you build a well-diversified portfolio and a long-term investment strategy.

Robert Scott, Senior Mortgage Advisor at Finance of America, gives a housing market update. 

34:30

Before the pandemic, interest rates were pushing 4 percent. Today, they’re at historic rock-bottom rates. Lots of homeowners and commercial real estate investors have questions about the current rate environment, future projections, and how the pandemic has impacted interest rates and the banking industry.

What does the current interest rate environment look like?

On the liability side of your balance sheet, your biggest line item is likely your mortgage. Properly addressing and taking care of that is absolutely key.

When the pandemic caused the economic shutdown, the banking industry was hit with liquidity issues. As such, risk factors in mortgage lending have become much more amplified. 

  • Good credit scores are all-important, and high debt-to-income ratios are more highly scrutinized

  • Property types (e.g., a condo is considered higher-risk than a single family residence)

  • Occupancy type (e.g., non-owner or investment properties are considered higher-risk than your principal residence)

  • Higher loan to values have virtually gone away

There’s a premium to be paid for crossing into some of these risk factors.

What impact has the pandemic had on interest rates and the banking industry?

What impact has the pandemic had on real estate values and the industry?

Some of the opportunities for the more risk-laden property products—whether you’re buying raw land or wanting to do construction—have diminished.

The jumbo market (i.e., greater than $765,000) has been in a state of shambles for a few months now, causing us to employ all sorts of different strategies to get up into the higher dollar amounts.

Home equity lines of credit (HELOC) tied to the prime rate have been impacted tremendously.

Leading up to the pandemic, we had a flattening of the yield curve—which is simply a situation where a longer-term yield doesn’t provide the same kind of difference in interest rate or yield return as a shorter-term yield. 

As a result, the comparative attractiveness of adjustable rate mortgages (ARMs)—you know, traditionally a five-year fixed-rate mortgage—is maybe one full percentage rate lower than a 30-year fixed rate mortgage. In today’s market, that yield curve has compressed so dramatically that oftentimes, 30-year fixed rate mortgages are priced more aggressively than ARMs.

Are we poised for another correction like we saw in 2008?

There’s a lot of chatter about a 2020 housing bubble. Many prospective buyers are opting to hold out on the sidelines, anticipating a decline in market values.

However, there are major differences between the 2008 recession and our current recession. It comes down to supply and demand. The demand for housing is highest among those in their 30s and 40s who are getting married and starting families.

Looking back in our demographic history, you can see two prominent flat areas of population growth in the U.S.: once right after the passage of Roe v. Wade, and another time right around 2007-2008. During these times, housing demand decreased dramatically. The absolute historical peak for residential real estate inventory was in 2007.

However, today, our current residential real estate inventory is at all-time historic lows. It is a very competitive market.

The laws of supply and demand tell us that if our demand is higher than our supply, we’ll still see upward pressure on prices.

You might think that means that home builders will address this lack of supply and build more homes. After we saw the bottom of the real estate market in 2011, you can see a tumble in new housing start permits. When COVID-19 happened, you can see a similar drop in permits.

The bottom line is, we’re still suffering from a lack of inventory and supply. There is still going to be quite a bit of demand and upward pressure on residential real estate prices.

When looking at the whole U.S., just over one-third of every household owns their property free and clear. Just over two-thirds of the country, or 53 million homeowners, has positive equity. Only 2 percent are underwater. 

If we were to look at the same pie chart back in 2008, 25 percent of the population—24 million out of 124 million households—was underwater. At that time, lending practices created excessive risks that led to the housing bubble, numerous defaults, and the ensuing recession.

As we all know, interest rates tend to come down during recessions. Significant interest rate drops boost affordability, which add strength to the housing market

Should I consider a refinance? If so, what strategy should I employ?

If you have an interest rate that’s higher than current market value, you absolutely should refinance unless your own is of a size that you can’t do it economically. 

When doing a refinance analysis, there are some strategies you can apply for a smart refi.

  • Cash flow. Say you want to lower your monthly payments for cash flow purposes.

  • Pay down principal balance. Maybe you’re heading into retirement and want to reduce your principal balance as quickly as possible.

  • Minimize interest exposure. Another idea is minimizing the interest expense that you pay on that loan. A shorter loan term will have higher payments and a slightly lower interest rate, but with an accelerated principal reduction and lower total interest required to pay off your loan, you’re in a position to liquidate your mortgage as quickly as possible. 

These are the kinds of strategies that you want to discuss with your Wealth Advisor.

I’m retired and would like to take advantage of these low interest rates but my income is reduced. Can I qualify?

If you’re working with a reduced income, you only need to show that you have access to the required money to qualify for the mortgage you’re interested in, as well as assets to last you 3 years. Qualifying income sources include:

  • Social Security

  • Pension

  • 401(k)

  • Other investment accounts

  • Discretionary distributions

For example, if you were to take a $10,000-a-month distribution, you just need to show $360,000 in that account to qualify for that mortgage.

Is a Reverse Mortgage an option that I should be considering? What are the pros and cons?

Reverse mortgages are increasing in popularity with seniors who have equity in their homes and want to supplement their income. A reverse mortgage is a type of loan that allows homeowners ages 62 and older, typically who've paid off their mortgage, to borrow part of their home's equity as tax-free income. 

If you own your house free and clear, you can pull out cash as a lump sum and use it to your discretion. For instance, you can incorporate it in your legacy planning strategy, or use it to supplement your grandchild’s college savings plan.

The primary attraction to the reverse mortgage is that it’s a non-recourse debt: a borrower can never owe more than their home is worth at the maturity of their reverse mortgage loan. 

The big question for millions of seniors is: Is it worth using this tappable equity, or do the risks outweigh the benefits?

The benefits are many:

  • Increased income. Many seniors experience a significant income reduction when they retire. With sufficient home equity, you can pull cash from the property with a reverse mortgage.

  • You can stay put. Rather than move, a reverse mortgage gives you the option of aging in place and being near friends and family.

  • You can potentially save on costs. There is a cost to reverse mortgages, but it may be cheaper to get a reverse mortgage than to move. Moving expenses include the cost of selling the home, moving household goods and either buying or renting replacement residence.

  • The money you get from a reverse mortgage is not taxable. Reverse mortgage payments are considered loan proceeds and not income.

  • And, perhaps most importantly, you retain ownership of your home. Reverse mortgages can be paid off by borrowers but typically end when individuals move, sell or pass away. In an estate situation, heirs have several choices: First, they can sell the property to repay the debt and keep any equity above the loan balance. Second, they can keep the home and refinance the reverse mortgage balance if the property’s value is sufficient. Third, if the debt exceeds the value of the property, heirs can settle the loan by giving the title back to the lender. The lender can then file a claim for any unpaid balance with the insurer, almost always the FHA.

However, there are some considerations to keep in mind:

  • Reverse financing has associated costs. Lender fees, FHA insurance charges and closing costs can be added to the loan balance; however, that means you have more debt and less equity.

  • Your home can still be foreclosed. If you don’t pay property taxes, maintain property insurance, fail to pay HOA bills, and so on, you may lose your home.

  • Status changes. Reverse mortgages get complicated. If you go to a long-term care facility, are you still considered a resident in the home? If you get married after getting a reverse mortgage, does your spouse move out of the property upon your death? For details regarding these and other questions, it’s best to speak with a lender or an attorney who specialize in elder law or contact a legal clinic.

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Disclaimer:

Prosperity Financial Group and Meet the Expert® with Elliot Kallen do not make specific investment recommendations on Meet the Expert® with Elliot Kallen or in any public media. Any specific mentions of funds or investments are strictly for illustrative purposes only and should not be taken as investment advice or acted upon by individual investors. The opinions expressed in this episode are those of the Meet the Expert® with Elliot Kallen guests, and not necessarily of Elliot Kallen or Prosperity Financial Group.

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