Rising Interest Rates and Your Home

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1 Viewpoint Timely Insights from the Private Banking & Investment Group NOVEMBER 2013 Rising Interest Rates and Your Home Finding opportunity in the current rate environment often starts with setting sentiment aside and treating your home as another asset. For years it seemed that low home mortgage rates could go only one direction: lower. Then rates rose significantly starting this past spring. Now, even among many ultra-high-networth clients for whom home financing costs may represent a relatively small part of their personal balance sheet, we re detecting a heightened sense of uncertainty concerning what to do in this rate environment, says Paul Fox, managing director and head of the Global Wealth and Investment Management (GWIM) Real Estate Group at Merrill Lynch. with adjustable-rate mortgages (ARMs) have been weighing whether to pay off their mortgages immediately in case rates start shooting up. Those with fixed-rate mortgages who were waiting for rates to drop one more notch before refinancing now fear the opportunity has vanished. And people who own their homes outright and thought of tapping that stored-up liquidity wonder whether a cash-out refinance still makes sense. The common thread, says Fox, is people feel like they may have missed the boat. The spike was prompted in part by comments by Federal Reserve (Fed) Chairman Ben Bernanke that the Fed might begin tapering its quantitative easing programs the massive purchases of U.S. Treasuries and other government securities that it had conducted since 2008 to stimulate the economy by lowering interest rates. Ever since, homeowners Fox believes much of the rate angst has to do with the special position a home occupies in many people s wealth planning discussions. It s a place that s full of memories. It s where they raised a family or spent their vacations. It s part of their lives. Thus, at the first sign of uncertainty, they may understandably be moved to protect their homes from seeming dangers or feel Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and other subsidiaries of Bank of America Corporation (BAC). The Private Banking and Investment Group is a division of MLPF&S that offers a broad array of personalized wealth management products and services. Both brokerage and investment advisory services (including financial planning) are offered by the Group s Private Wealth Advisors through MLPF&S. The nature and degree of advice and assistance provided, the fees charged, and client rights and Merrill Lynch s obligations will differ among these services. Investments involve risk, including the possible loss of principal investment. The banking, credit and trust services sold by the Group s Private Wealth Advisors are offered by licensed banks and trust companies, including Bank of America, N.A., member FDIC, and other affiliated banks. Investment products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value MLPF&S is a registered broker-dealer, a registered investment advisor, member SIPC and a wholly owned subsidiary of BAC.

2 rushed into making certain decisions without having the chance to consider all of the factors involved. That s why in working with financial advisors and their clients on their response to the rate hikes, Fox has been encouraging a somewhat more hard-nosed attitude toward hearth and home. We start by trying to get people to think about their house as an asset just like any other asset, he says. You may still have an emotional attachment, but once you are able to look beyond that, you have quite a bit more room and freedom to consider your options. It goes from being a source of pressure and concern to a source of potential opportunity. KEEPING RATES IN PERSPECTIVE Once emotions are temporarily set aside, it can also help to take a step back and put today s rate increases in perspective. First, while rates are likely to rise, the sense of urgency to respond right away may be misplaced. When rates rose in response to Bernanke s comments, mortgage applications nationwide dropped by 15% from May through early September. Chris Flanagan, head of U.S. mortgage and structured finance research for BofA Merrill Lynch Global Research, thinks the suddenness of homebuyers and owners reaction took the Fed by surprise and likely played into its more tentative comments in the months that followed. I think what we ve learned over the past several months is Going Up? Mortgage rates have inched up with talk of tapering and passing fears of government default but aren t taking off. MORTGAGE RATE (%) Source: Bankrate Inc. Data as of 10/22/13. Conventional 30-year rate Conventional 15-year rate 5/1 ARM rate (with years 1 5 fixed) Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Jul 13 Oct 13 The housing market is so essential to the overall economy that the Fed is under tremendous pressure not to jeopardize its recovery. that the Fed is going to have to play this in a very balanced way, says Flanagan. The housing market is so essential to the overall economy that the Fed is under tremendous pressure not to jeopardize its recovery. Second, even as longer-term interest rates rise, short-term rates that influence adjustable-rate mortgages are unlikely to begin rising for another year or so, says Marty Mauro, fixed income strategist for BofA Merrill Lynch Global Research. The Fed has stated that it intends to keep the federal funds rate, its short-term benchmark rate, near zero until the U.S. unemployment rate falls to 6.5% or lower. And we have a while to go before that happens, Mauro notes. The takeaway for people considering changes to their ARMs: You may have more time than you think. Finally, it s important to keep in mind that by almost any historical standard, rates today are still remarkably low. Yes, we ve seen extraordinarily low levels in recent years, and we may not see 10-year Treasuries at 1.5% again in our lifetimes, Mauro says. But, in our view, there is no indication we re heading back to 10%, 11% or 12% like we saw in the 1970s and early 1980s. It s more likely we ll see 4% to 5%. A TIME OF OPPORTUNITY Now, imagine those same conditions a clear sense of market direction, ample time to act, prices near historic lows were in place for any other asset in your portfolio. The fact is, when viewed purely in financial terms, many homes remain an attractive form of capital. Consider, for example, a couple seeking a source of liquid cash to purchase a piece of land, start an art collection or VIEWPOINT 2

3 part-time commercial venture or pursue some other opportunity. Like many wealthy homeowners, this couple owns their home outright. And amid the housing recovery, the home has increased significantly in value. When they consider all of the potential sources of liquidity available to them, a cash-out mortgage may still very well be one of their best options. After all, though mortgage rates have inched up of late, they still remain well below the rates of other sources such as credit cards or other types of bank loans, which have seen increases as well. A securities-backed loan might offer lower rates, but it also comes with the risk that the loan could be called if the securities drop below a certain value. Other alternatives, such as selling stocks for liquidity, meanwhile, might mean missing out on growth potential at a time when equities markets have been performing well. When you treat your home as an asset, it can become an attractive way to pursue specific goals. There are limits to the uses of a cash-out, however. For example, the Dodd-Frank Financial Reform Act, passed in 2010, prohibits taking cash out of a home for investing in stocks or other marketable securities. Such rules are complex, so it s vital to speak with your financial advisor and tax specialist before making any decisions. The important thing, says Fox, is to think of your home as another tool. When you treat your home as an asset, it can become an attractive way to pursue specific goals. It s another source of liquidity. IN THE INTEREST OF YOUR GOALS Viewing a home in the context of personal financial goals can also help provide clarity for those mulling over other types of home financing decisions. Raj Bhatia, a Private Wealth Advisor based in Chicago, worked with the GWIM Custom Credit and Lending group on behalf of a client, a 62-year-old entrepreneur who had held a series of ARMs on his California home, and had been refinancing periodically to capture lower and lower rates. ARMs typically carry a fixed rate for a certain number of years, after which the rates will vary according to the market. Although this homeowner still has two years at fixed low rates on his current ARM, he s concerned that two years from now, rates could be significantly higher. As a solution, he has decided to refinance now, Bhatia says. But instead of going into a traditional fixed-rate mortgage, he s looking at another, longer-term ARM. Even though his new loan may involve a slightly higher rate than what he s currently paying, the rate is still likely to be low according to historical standards, and will assure him of attractive payments for the better part of a decade. Moreover, the client is confident that the length of the ARM gives him more than enough of a window in which to plan his next move whether that s to pay off the mortgage or sell the property. By the same token, those in the market for a new home should try not to let less-than-perfect timing on interest rates get in the way of everything else they are trying to achieve, says Elizabeth Carasaniti Cino, director of custom residential real estate lending for the GWIM Real Estate Group. Because wealthy individuals and families have sophisticated finances and complex needs, interest rates are often just one of many factors playing into how their mortgages are structured, she says. They may have to factor in a liquidity event, such as the sale of a business. They may be trying to time a prospective loan so that it ends before some other major expense or investment opportunity kicks in. It s really about tailoring a solution specific to their situation. Recently, Carasaniti Cino worked with one wealthy couple seeking to finance a multimillion-dollar home purchase on the West Coast. A detailed conversation revealed a host of goals that needed to be factored in. Among the couple s priorities were having the home paid off by the time their youngest child went to college, minimizing monthly payments and making use of an influx of cash from an inherited family property, the sale of which they anticipated being completed sometime within three years. VIEWPOINT 3

4 Carasaniti Cino and her team helped structure a package of three separate mortgages, totalling more than $6 million, each addressing a different goal. The first was a long-term fixedrate mortgage covering $1 million of the total sale price. Since the IRS allows mortgage interest deductions on only the first $1 million in principal, this first loan gave the couple their full potential deductions, while offering an attractive fixed interest rate. The second loan was a shorter-term ARM with a rate fixed for the first several years and then adjusted once per year thereafter. Additionally, this mortgage allowed for interest-only payments enabling the owners to make low monthly payments and chip away at the principal at intervals. The third and final mortgage was a very-short-term balloon offering low rates with the balance ( the balloon ) timed to the outer limit of when the income from the inherited property was expected to come through. Within such a customized strategy, rising or falling interest rates should take a back seat to the individual s larger goals, Carasaniti Cino says. Regardless of the direction of interest rates, she says, You re much more focused on what it is that you are really trying to achieve. Homes, of course, will always carry a special personal resonance. A child s bedroom, a favorite reading porch, the family game room and the kitchen table store precious memories in a way that a thousand shares of stock never will. Yet, the more businesslike a homeowner can be when thinking of the financial decisions involved in homeownership, ironically, the more joy the home may be able to bring. VIEWPOINT 4

5 Past performance is no guarantee of future results. The opinions, assumptions, estimates and views expressed are as of the date of this publication, are subject to change, and do not necessarily reflect the opinions and views of Bank of America Corporation or any of its affiliates. The information does not constitute advice for making any investment decision or its tax consequences and is not intended as a recommendation, offer or solicitation for the purchase or sale of any investment product or service. Before acting on the information provided, you should consider suitability for your circumstances and, if necessary, seek professional advice. Neither Merrill Lynch nor its Financial Advisors provide tax advice. Please consult your tax advisor regarding the deductibility of mortgage interest. Interest rates and market conditions are always subject to change. Exact situation will depend on facts and circumstances. Any information presented in connection with BofA Merrill Lynch Global Research is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investment objectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects may not be realized. U.S. Trust operates through Bank of America, N.A., member FDIC Bank of America Corporation. All rights reserved. ARRCDTSJ