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5/7/07 Weekly Inquiry

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May 2007 Monthly Interview

This month we are pleased to talk with Michael Cordova, Vice-President of Milestone Mortgage, Team Cordova.   Michael has closed over a half billion dollars in loan production over 23 years in his practice.  He is a licensed Registered Mortgage Advisor, California Mortgage Planning Specialist, and a member of the By Referral Only College of Business Philosophy.   He has been a licensed California Mortgage Loan consultant since 1978.  Michael is licensed to practice Missed Fortune Equity Management and Wealth Creation Strategies having graduated from Missed Fortune Academy of Asset and Debt Management.   He earned a B.S. in Financial Investments from California State University , Long Beach and minored in Real Estate Investment in 1978.For more information, visit www.milestonemtg.com/teamcordova.

There seems to be a lot of concern right now about interest rates.   How does mortgage interest work for us instead of against us?

That’s a great question.   I tell my clients that there are basically two types of interest, there’s good interest and bad interest.  Or I’ll say preferred interest and non-preferred interest.    Basically what that means is that preferred interest is tax deductible and mortgage interest falls into the category of preferred interest and is a write off.  An example of non-preferred interest or something that is not a write-off would be auto or credit card interest.  

So for a quick example, let’s say you have a married couple who combined earn $70,000 a year and they have $10,000 in mortgage interest.   Their taxable income decreases from $70,000 down to $60,000 because of the $10,000 interest write off.  And in a 33% combined state and federal tax bracket, this couple would save $3,300 in income tax on Schedule A of their 1040 tax return.   Therefore, interest that is preferred or good interest can be a good thing because it is a write off.

I have been hearing something about the IRS checkbox on the 1098 form, acquisition indebtedness…what’s that all about?

The 1098 interest form outlines how much mortgage interest you have paid during the year.   There’s going to be a box that the existing investor is now going to check if and when there is a cash out refinance and the reason for that is the IRS is now going to be monitoring how much interest people are going to deduct on their 1040 tax return and make sure it is within the guidelines of the IRS.  

Let me just say just this about the definition of acquisition indebtedness, home owners can deduct mortgage interest on Schedule A of an itemized tax return up to $100,000 over and above the acquisition indebtedness of a qualifying residence.   Qualifying residence is the primary or secondary home.  This is true unless the loan proceeds are used to increase the acquisition indebtedness by doing home improvements on the qualified residence up to a maximum loan limitation of $1,000,000.  Also, most people don’t understand that their acquisition indebtedness decreases with each principal payment that is made.

Let me just give you an example.   If you have an original purchase price of $800,000 with $400,000 down, you would have an initial loan amount or acquisition indebtedness of $400,000.  Therefore the client would be writing off interest on $400,000.   Let’s fast forward a little bit to four years later.  You get a loan or the house goes up in appreciation to $1,000,000.   The loan balance is paid down to $350,000 and because they have equity in their property, the clients want to take out $250,000 cash up front to pay off non-preferred debt such as credit cards or car payments.   So in this example, they would take out a loan of $600,000.  The question I would ask the clients is do they know how much of that they are going to be able to write off?   The answer is the acquisition indebtedness has decreased to $350,000 from the original loan balance of $400,000.  However, with $100,000 over and above the acquisition indebtedness exemption, the client can write off interest on the loan amount only up to $450,000.  Therefore, Christine, you can see how interest only loans and equity management strategies can be a great advantage in keeping your acquisition indebtedness at the highest level for a great tax advantage hedge and still accelerating the payoff of your mortgage.  

People need to be aware that the IRS is going to be looking at this much more stringently.   I don’t think the IRS has paid as much attention to this in the past as they are going to in the future.  Income in real estate investments produces dollars in tax revenue and I think this will become an issue starting next year.

Let’s talk about equity and what constitutes a prudent investment.   Reading from Douglas Andrew’s book Missed Fortune 101, he says that when considering a particular investment (including real estate), we should look at three things: liquidity, safety, and rate of return.   How does equity fare against these three?

For people out there who have not read Douglas Andrew’s book Missed Fortune 101, I highly recommend it.  When I read it for the first time, I absolutely had a huge paradigm shift when it came to issues of equity and equity management, liquidity, rate of return, and how I view my mortgage.   I come from a very conservative background where mortgages are looked at almost as a necessary evil or as something that you want to get rid of as fast as possible.   I think that came from generations of thinking back to the great depression and this book helped change that mentality of how important equity is if it’s used correctly and planned correctly.   Also by reading the book, I had a change in my philosophy in regards to money.   

If we look back 40 years ago, things were very different.   Back then someone may have gone to college and then entered the job market let’s say to General Motors.  At this point they would work very hard, get job promotions, earn a good salary and a good pension. They would earn a nice retirement nest egg and go into retirement with liquidity.   Fast forward 40 years.  People are not staying on the job for 30 years and retiring.  They are changing jobs five or six times during a lifetime.   They are looking for more choice and control over their money and this is where equity comes in and the equity management philosophy. 

Equity is the difference between what a ready, willing, and able buyer will pay for a property and what is owed.  Americans typically believe that home equity is a good investment.  67% of Americans have their net worth in their home equity rather than another investment.  If you ask 100 financial planners if having 67% of your portfolio
in one investment or one asset would be prudent, they would say it is not prudent.

Regarding liquidity…how easy is it to get to your equity?   It’s not easy at all.  I would say the number one reason for foreclosures is because of lack of liquidity not because of bad loans. It’s because of an inability to get to your money.  

Let’s say you have a perfect payment history on a loan and then suddenly something occurred where you lose your job.   And you’ve had perfect payment history for 24 or 36 months.  You may have even been paying more on the principal.   Then you go into the bank because you lost your job and you ask for a little bit of payment relief.  What do you think the answer is going to be?   Also if something comes up where you have a disability and perhaps you don’t have disability insurance or you might be going through some difficult financial times…what you rather have?   $25,000 of equity trapped in your property or $25,000 in a safe liquid side fund earning a rate of return?  So if you ask anybody who has lost their house in a foreclosure, they would probably tell you that they would have been far better off having their equity separated from their bricks and mortar, including Douglas Andrew who lost his home to foreclosure.   In his book he tells about the $150,000 liquidity lesson that he had to go through.

How safe is your equity?   Let’s talk about safety when it comes to the southern California area.  Over a decade ago, real estate prices took a 20% to 30% dive and people found out the hard way that real estate equity is no safer than any other investment. This is controlled by what I would consider external factors in our market place.   People have no control over the job market, companies leaving town, and so on.

Another example with safety… Houston, Texas was hit pretty hard by oil prices.   They were at an all time low in the 1980’s.  I would say thousands of workers were laid off and had to sell their houses.   But there was such a glut of houses at that particular time, there were far too many sellers and certainly not enough buyers.  16,000 lost their homes to foreclosures.   Did these 16,000 people suddenly become bad people?  The bottom line is they couldn’t afford their mortgage.  I bet if you ask them today if they had had a crystal ball to see into the future, would they rather have had their equity trapped in their property or separated where they could get to it?  

Rate of return. How much does your equity earn as far as rate of return?   There is a misconception in that people believe there is a rate of return on their equity.  However, there is zero rate of return on equity.   There is a difference between rate of return and appreciation.  Appreciation values go up or down depending on the market place and external factors.   Home values fluctuate due to market conditions not due to mortgage balances.  Equity in a home has no relation to home value and is in no way responsible for appreciation or depreciation.  

So rate of return is completely separate from appreciation or depreciation?

Yes, and it’s important for people to know that.   Now where rate of return comes in is when a client comes to me and wants to strip some of their equity out of their property and put it to work so it can earn a rate of return. I show my clients how to take advantage of other home equity strategies by employing their home equity and earning a rate of return greater than the cost of the mortgage interest.

Is it possible for people to separate and manage their equity to better increase liquidity, safety, and rate of return so they can conserve their equity and not consume it?

Absolutely, that’s what we are doing here at Team Cordova, Milestone Mortgage.   What we teach is the Bank of You paradigm.  We are teaching our clients to be the bank or to do what banks do rather than what banks want you to do.   Banks take our money and give us a rate of return of 1% to 2% typically and then they take our money and turn around and reinvest it back to us in the form of credit cards, car loans, and mortgages and earn interest at the rate of 6% to 22% in some cases and that spread or arbitrage is the profit the banks earns for employing our money.  Team Cordova teaches our clients to do the same thing.   We are teaching our clients that regardless of what interest rates are, they can take their money and invest it in a very safe, very secure investment that can earn a rate of return equal to or greater than the cost of employing that money or equity.

For example, if they are borrowing money at 6%, we guide them to investments with a rate of return typically between 6% to 8.5%.   Looking at that scenario, if someone is earning a rate of return of 8.5% in a safe and liquid investment and they are borrowing at 6% and Uncle Sam is paying about one-third as a tax write off of mortgage interest, they are earning a spread arbitrage of between 4% and 8.5%.  That’s a tremendous rate of return, and it’s secure and safe and that’s what we are teaching. 

So learning to control and manage equity successfully is the key to enhancing your financial net worth?

Absolutely.  And it is important to keep in mind that none of this works if people are not concerned with conserving their equity rather than consuming it.  I just want to point out the importance of accountability on both sides.   We are connecting our clients with great financial planners and people who are very much experts at teaching our clients where to put their assets so they can earn this type of rate of return.   We are also doing follow up at six months and twelve months so we stay in close contact and make sure there is accountability on both sides.  If someone came to me and wanted to take their equity to buy a boat or jet ski, none of this would work. 

What is the first step someone should take in order to manage their mortgage to create wealth?

I‘m a big believer in getting educated.   Get educated on home equity and mortgage planning.  There are some great books out there. We have mentioned Douglas Andrew’s Missed Fortune 101 .  Doug is coming out with a new book, Last Chance Millionaire. There is wonderful book called Ordinary People, Extraordinary Wealth by Rick Edelman.  Also, I have great article if anyone would like a copy.  It is written by Steven Marshall on “How the Affluent Manage Home Equity.”   It is about equity management and wealth creation strategies.

If anyone would like to delve deeper into how this all would affect their own personal situation, they can contact me and I would be more than happy to help them analyze their mortgage situation.   If they stripped $100,000 of equity out of their property, we can turn that into $1,000,000 in a thirty year period.  If we can do that with $100,000, imagine what we can do with other idle dollars sitting in their house through appreciation of their property.   We can take it and invest it and concentrate on liquidity and safety.  I tell my clients, just dream with me.   Imagine what we can do if you have more than $100,000 in equity!

Every time we take equity out of a property, we are getting closer and closer to what we call Freedom Point.   Freedom Point is where there is enough asset on the outside of the property to pay for the debt on the inside of the property.  It is a transforming time to help a client get to Freedom Point.   I’m very blessed to be able to that.

So the goal is Freedom Point, not paying off the mortgage?

That’s right.  Freedom Point allows you to have the choice and control that if you ever wanted to draft a check to pay off your mortgage, you could.  However, when people get to this point, we never advise them to write that check because, again, Uncle Sam is our greatest partner in interest write off.   Further and further beyond Freedom Point is where there is the opportunity for true creation of wealth.

What do you as a mortgage consultant offer to the person reading this interview?

I teach my clients how to merge the assets and debts on their balance sheet and how simple planning can ensure their retirement, their child’s education, they have funds set aside in case of emergencies or financial hardship.  

Thank you.  

Michael Cordova can be reached at michaelc@milestonemtg.com or 310-732-0011.

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