Why Leveraged ETFs Don't Always Boost Returns

Filed Under: Active Trading, ETFs

In recent years, exchange traded funds (ETF) have grown massively popular, and for many good reasons. ETFs have some attractive characteristics and provide individual investors an easy way to gain sector or broad market exposure. However, ETFs don't always work the way you may expect judging by their names. Many people who look at the returns of an ETF, compared to its respective index, get confused when things don't seem to add up. Investors should know the following factors when investing using ETFs. (Learn more in Ultra ETFs: The Ultimate Investment?)

Does Leveraging Work?Leveraged ETFs feature some of the most glaring naming mistakes when investing over an extended period. These ETFs generally come with the names "Ultra Long" or "Ultra Short," and if you look into their descriptions they promise two to three times the returns of a respective index, which they do - sort of. Let's look at a few examples of how ETFs don't always work the way you would expect.

The Ultra S&P 500 ProShares is an ETF designed to return twice the S&P 500. Leveraged ETFs boost results, not by actually borrowing money, but by using a combination of swaps and other derivatives. However, the effect is the same, and if the S&P 500 returns 1%, the SSO should return about 2%. But let's look at an actual example. During the first half of 2009, the S&P 500 rose about 1.8%. If the SSO had worked, you would expect a 3.6% return. In reality, the SSO went down from $26.27 to $26.14. Instead of returning 3.6%, the ETF was essentially flat.

It's even more troubling when you look at the SSO along with its counterpart, the UltraShort S&P 500 ProShares which is designed to return twice the opposite of the S&P 500. Over the 12 months ending June 30, 2009, the S&P 500 was down nearly 30%. The SSO behaved pretty well and was down about 60%, as you would expect. The SDS, however, was down about 20%, when it should be expected to be up 60%! (Learn more in Dissecting Leveraged ETF Returns.)

Are SPDRs More Predictable?Leveraged ETFs aren't the only ones with problems. S&P 500 Depository Receipts, also known as SPDRs, seek to exactly mimic the S&P 500. Over the twelve months ending June 30, 2009, SPY shares were down just under 30%, which is about right. Its counterpart, however, Short S&P 500 ProShares, which seeks to move exactly the opposite, was curiously down around 4% during the period.

The CausesSo now that we've looked at a few examples of how ETFs don't always do what they are supposed to do, let's examine why. ETFs are really designed and marketed to track the daily movements of a corresponding index. You may ask yourself why that would matter, since if it tracks its index properly each day, it should work over any extended period of time. That is not the case. The compounding effects of daily returns will actually throw off the math, and can do so in a very drastic way.

Leveraged ETFsFor example, if the S&P 500 moves down 5%, the SSO should move down 10%. If we assume a share price of $10, the SSO should be down to about $9 after the first day. On the second day if the S&P 500 moves up 5%, over the two days the S&P 500 return will be -0.25%. An unaware investor would think the SSO should be down 0.5%. The 10% increase on day two will bring shares up from $9-9.90, and the SSO will, in reality, be down by 1%. It decreases a full four times the decline of the S&P 500. Typically, you will find that the more volatile the benchmark (S&P 500 in this example) for a leveraged ETF, the more value the ETF will lose over time, even if the benchmark ends up flat or had a 0% return at the end of the year. If the benchmark moved up and down drastically along the way, you may end up losing a significant percentage of the value of the ETF if you bought and held it.

Normal ETFsAs for the problems with normal ETFs, the math works similarly, but on a smaller scale. If you start at an index value of 100 and it drops 5% on the first day, a long ETF with a starting value of $100 will drop 5% to $95, while the short ETF also at $100 will increase 5% to $105. If on the next day, the index rebounds by increasing 5%, the short ETF will drop 5% to $99.75 [105 x (1-0.05)], and the long ETF will rise 5% to $99.75 [95 x (1+0.05)]. Both end up at the same value, and both have dropped 0.25%, when they are supposed to be inverses of one another. Taking this over more extended periods can cause even more accentuated problems. In volatile markets, like those seen in 2008 and 2009, even unleveraged ETFs can show significant discrepancies. (See Investment Strategies For Volatile Markets to learn how to adapt your strategy based on market conditions.)

We used the S&P 500, and its corresponding ETFs, as the basis for all of the examples above because they are some of the most visible and heavily traded ETFs, but there are similar ETFs designed for other indexes and sectors, where all the same rules apply. Long, unleveraged ETFs will generally behave as you would expect when comparing with its index. Levered and short ETFs, however, can look like they have significant differences, especially when an unknowing investor buys one as a long-term investment. ETFs can be useful for short-term plays, but many are not the best choice as long-term plays.

ConclusionCompanies that sponsor ETFs outline the issues that investors will likely experience, if holding the ETF over an extended period of time. Many ETFs are generally designed for short-term (daily) plays on an index or sector, and should be used that way. Most, except long unleveraged ETFs, will not work as you may expect over a long period of time, especially in volatile markets.
For additional reading on ETFs, take a look at Mutual Fund Or ETF: Which Is Right For You?
by Wayne Pinsent (Contact Author | Biography)

Filed Under: Active Trading, ETFs

The Gold Showdown: ETFs Versus Futures

Filed Under: Commodities, ETFs, Futures

In 2004, the first exchange-traded fund (ETF) specifically developed to track the price of gold was introduced in the United States. It was touted as an inexpensive alternative to owning physical gold or buying gold futures, and since its introduction ETFs have become a widely accepted alternative. Many investors look to certain gold-specific ETFs as a convenient and exciting way to participate in gold without having to be exposed to the risks of physically purchasing bullion or becoming savvy on how gold futures operate. However, what many investors fail to realize is that the price to trade ETFs that track gold may exceed their convenience and that trading gold future contracts may be a better alternative under the right circumstances. In this article we'll explore whether it's better to invest in gold ETFs or to go with the more traditional gold futures. (To begin with the basics, read Getting Into The Gold Market.)

Problems With Gold ETFs
For more sophisticated investors, or those with investing capital that exceeds a few hundred dollars, there are significant drawbacks to investing in gold-specific ETFs that go beyond the day-to-day fluctuation of gold prices. These problems include tax implications, non-gold related market risk and additional fees.

Problem No.1 - Taxed as a CollectibleAn investment in an ETF that tracks gold prices does not consist of actual gold ownership on the part of the shareholders. An investor cannot make a claim on any of the gold shares and under IRS law, their ownership in the ETF represents an ownership in a "collectible". Despite the fact that the managers of gold ETFs do not make investments in gold for their numismatic value, nor do they seek out collectible coins, the shareholder's investment is treated as a collectible. This makes long-term investing in gold ETFs (for one year or longer) subject to a relatively large capital gains tax (maximum rate of 28%, rather than the 15% rate that is applicable to most other long-term capital gains). In order to avoid this tax implication, investors often exit their positions before a year, which diminishes their ability to profit from any multiyear gains that may occur in gold. (For added insight, see Contemplating Collectible Investments.)

Problem No.2 - Market Risk
Exchange-traded funds that track gold are also exposed to a hosts of company risks that have nothing to do with the actual fluctuation in gold's value. In the SPDR Gold Trust prospectus, for example, the trust can liquidate when the dollars in the trust fall below a certain level, if the net asset value (NAV) drops below a certain level, or by agreement of shareholders owning at least 66.6% of all outstanding shares. These actions can be taken regardless of whether gold prices are strong or weak.

Problem No.3 - Fees, Fees and More Fees
Finally, gold ETFs are inherently diminishing investments. Because the gold itself produces no income and there are still expenses that must be covered, the ETF's management is allowed to sell gold to cover these expenses. Each sale of gold by the trust is a taxable event to shareholders. That means that a fund's  management fee along with any sponsor or marketing fees must be paid by liquidating assets. This diminishes the overall underlying assets per share, which, in turn, can leave investors with a representative share value of less than one-tenth of an ounce of gold over time. This can lead to discrepancies in the actual value of the underlying gold asset and the listed value of the ETF. (For related reading, check out The Hidden Costs Of Investing.)

Given these drawbacks, many ETF investors turn their attention to trading gold futures.

Think About Gold Futures
The risks that gold-focused ETFs have are not seen in gold futures. Gold futures, in comparison to the ETFs, are fairly straightforward. Investors are able to buy or sell gold at their discretion. There are no management fees, taxes are split between short-term and long-term capital gains, there are no third parties making decisions on investors' behalf, and at any time investors can own the underlying gold. Finally, because of margin, every $1 that's put up in gold futures can represent $20 or more worth of gold.

For example, while a $500 investment in an ETF such as GLD would represent half of an ounce of gold (assuming gold was trading at $1,000), using that same $500 an investor can have a mini-futures gold contract that represents 33 ounces of gold. The drawback to this kind of leverage is that investors can both profit and lose money based on 33 ounces of gold. Couple the leverage of futures contracts with their periodic expiration and it becomes clear why many investors turn to an investment in an ETF without really understanding the fine print. (For more, see Trading Gold And Silver Futures Contracts.)

ConclusionETFs and gold futures both represent a diversification into the metals asset class. There are pros and cons to both instruments, but that doesn't automatically make gold-specific ETFs superior to gold futures. Investors must be aware that, while on the surface an ETF can instantly create portfolio reallocation in one place, the fund may end up costing them more than they expected in both taxes and management fees on the back end.

by Noble DraKoln (Contact Author | Biography)

Noble DraKoln is founder and President of Liverpool Trading Company, and Speculator Academy. He is a licensed futures professional. He has been a guest speaker at various futures and forex trading conferences around the world including Los Angeles, Las Vegas, Chicago, New York, Paris, Frankfurt and Madrid, and is a former editor of Futures Magazine. His new book "Winning the Trading Game" is set to be released in March 2008 and is currently available on Amazon.com.

Filed Under: Commodities, ETFs, Futures

How To Pump Up Your Portfolio With ETFs

Filed Under: ETFs, Mutual Funds, Portfolio Management

Similar to mutual funds, exchange-traded funds (ETFs) allow access to a number of types of stocks and bonds (or asset classes), provide an efficient means to construct a fully diversified portfolio, include index- and more active-management strategies, and are comprised of individual stocks or bonds. But ETFs also differ from mutual funds, and in ways that are advantageous to investors.
Unlike mutual funds, ETFs are traded like any stock or bond and offer liquidity throughout the day. Moreover, ETFs generally do not pay out dividends and capital gains - instead, distributions are rolled into the trading price, allowing investors to avoid a taxable event.
In this article, we'll show you how to add these funds to your portfolio to make it more liquid, user-friendly and profitable.

Tutorial: All About Exchange-Traded Funds (ETFs)
Portfolio ConstructionModern portfolio construction theory (MPT) is centered on the concept that asset classes behave differently from one another. This means each asset class has its own unique risk and return profile, and reacts differently during various economic events and cycles. The idea of combining various asset classes, each with unique attributes, is the basis for building a diversified portfolio. ETFs provide small investors with a vehicle to achieve asset class diversification, substantially reducing overall portfolio risk. (To learn more about MPT, see Modern Portfolio Theory: An Overview.)
Risk reduction is a concept that means many things to many people; therefore, a brief discussion of its use in this context is warranted.
Reducing RiskMany investors believe that by holding a portfolio of 30 or more U.S. large-cap stocks, they are achieving sufficient diversification. This is true in that they are diversifying against company-specific risk, but such a portfolio is not diversified against the systematic behavior of U.S. large-cap stocks.
For example, U.S. large-cap stocks' monthly returns as a whole averaged in the high teens, as seen in the S&P 500's 15% average return between 1997 to 2007. So this means that if you held just U.S. large-cap stocks, you should reasonably expect to see volatility in your portfolio of plus or minus 15% on any given month. Such a high degree of volatility could be unsettling and drive irrational behavior such as selling out of fear or buying and leveraging out of greed. As such, risk reduction in this context would involve the minimization of monthly fluctuations in portfolio value.
Many ETF Asset ClassesThere are many equity asset class exposures available through ETFs. These include international large-cap stocks, U.S. mid- and small-cap stocks, emerging market stocks, and sector ETFs. Although some of these asset classes are more volatile than U.S. large caps traditionally, they can be combined to minimize portfolio volatility with a high degree of certainty. Simply put, this is because they generally "zig" and "zag" in different directions at different times. However, in times of extreme market stress, all equity markets tend to behave poorly over the short term. Because of this, investors should consider adding fixed-income exposure to their portfolios.
ETFs also offer exposure to U.S. nominal and inflation-protected fixed income. Unlike equities, fixed-income asset classes generally offer mid-single-digit levels of volatility, making them ideal tools to reduce total portfolio risk. However, investors must be careful to neither use too little or too much fixed income given their investment horizons. You can even purchase ETFs that track commodities such as gold or silver or funds that gain when the overall market falls.
Investment HorizonAn individual's investment horizon generally depends on the number of years until that person's retirement. So, recent college graduates have about a 40-year time horizon (long-term), middle-aged people about a 20-year time horizon (mid-term), and those nearing or at retirement have a time horizon of zero-10 years (short-term). Considering that equity investments can easily underperform bonds over periods as long as 10 years and that bear markets can last many years, investors must have a healthy fear of market volatility and budget their risk appropriately. (Read more about time horizons in Seven Common Investor Mistakes and The Seasons Of An Investor's Life.)
Let's look at an example:

Example - Investment Horizon and Risk It could be appropriate for a recent college graduate to adopt a 100% equity allocation. Conversely, it could be inappropriate for someone five years away from retirement to adopt such an aggressive posture. Nonetheless, it is not uncommon to see individuals with insufficient retirement assets bet on equity market appreciation to overcome savings shortfalls. This is the greedy side of investor behavior, which could rapidly turn to fear in the face of a bear market, leading to disastrous results. Keep in mind that saving appropriately is just as important as how you structure your investments. (Find out who shouldn't be involved in 100% equity allocation in The All-Equities Portfolio Fallacy.)

ETF Advantages in Portfolio ConstructionIn the context of portfolio construction, ETFs (especially index ETFs) offer many advantages over mutual funds. First and foremost, index ETFs are very cheap relative to any actively managed retail mutual fund. Such funds will typically charge about 1-1.5%, whereas index ETFs charge fees around 0.25-0.50%. Consider the benefits of saving 1% in fees on a $1-million portfolio - $10,000 per annum. Fee savings add up over time and should not be discounted during your portfolio design process.
Additionally, index ETFs sidestep another potential pitfall for individual investors: the risk that actively managed retail funds will fail to succeed. Generally speaking, individual investors are often ill-equipped to evaluate the prospective success of an actively managed fund. This is due to a lack of analytical tools, access to portfolio managers and an overall lack of a sophisticated understanding of investments. Studies have shown that active managers generally fail to beat relevant market indexes over time. As such, picking a successful manager is difficult for even trained investment professionals.
Individual investors should therefore avoid active managers and the need to continuously watch, analyze and evaluate success or failure. Moreover, because the majority of your portfolio's return will be determined by asset class exposures, there is little benefit to this pursuit. Avoiding active managers through index ETFs is yet another way to diversify and reduce portfolio risk. (To find out more about management, read Words From The Wise On Active Management.)
ConclusionIndex ETFs can be a valuable tool to individual investors in constructing a fully diversified portfolio. They offer cheap access to systematic risk exposures such as the various U.S. and international equity asset classes as well fixed-income investments. They are traded daily like stock and can be purchased cheaply through your favorite discount brokerage firm. Index ETFs also avoid the risks of active management and the headaches of monitoring and evaluating those types of products. All in all, index ETFs offer unsophisticated investors the opportunity to build a relatively sophisticated portfolio with few headaches and at substantial cost savings. Consider them seriously in your investment activities. 
by Eric Petroff (Contact Author | Biography)

Eric Petroff is the director of research of Wurts & Associates, an institutional consulting firm advising nearly $40 billion in client assets. Before joining Wurts & Associates, Petroff spent eight years at Hammond Associates in St. Louis, another institutional consulting firm, where he was a senior consultant and shareholder. Prior to Hammond Associates, he spent five years in the brokerage industry advising retail clientele and even served as an equity and options trader for three of those years. He speaks often at conferences and has published dozens of articles for Investopedia.com and the New Zealand Investor Magazine.

Filed Under: ETFs, Mutual Funds, Portfolio Management

The Unique Advantages Of VA Mortgages

Filed Under: Home Insurance, Mortgages

There was a time when Veterans Administration (VA) loans were so time-consuming to obtain that lenders did not want to process them and home sellers were likely to reject offers from buyers planning to finance with VA loans. Thanks to changes in the system, it has become much easier to take advantage of the unique benefits offered by VA loans.

BackgroundVA loans are offered through the Veterans Administration, a U.S. government organization that provides benefits and services to eligible veterans, active duty, reservists and National Guard members along with their families. While the VA does encourage lenders to offer these loans by guaranteeing to repay a significant percentage of any loan that goes into default, VA loans are actually made by private lenders, not by the VA itself. This means that the lender, not the VA, determines whether a borrower is eligible for a loan and what loan terms the borrower qualifies for. As such, it’s still important to shop around for the best deal on a VA mortgage.

Unique Characteristics: No Down Payment, No PMIA few years ago, lots of lenders were offering 0%-down loans. After the housing market crashed, that option disappeared. The VA loan program, however, still offers the option to buy a home with no down payment. Not having to make a down payment will help you maintain your emergency fund, which is crucial when you're a homeowner. And if you already have plenty of money in your emergency fund, not having to make a down payment might allow you to make repairs or renovations that you couldn't otherwise afford. (Find out how to find the best mortgage possible, read Score A Cheap Mortgage.)

Here's an illustration of how much money you can hang onto in the short-term with a zero-down payment loan:
 

	Traditional Down Payment	Conventional Loan	FHA Loan	VA Loan
Down Payment Percentage	20%	10%	3.50%	0%
Purchase Price	$200,000	$200,000	$200,000	$200,000
Down Payment Amount	$40,000	$20,000	$7,000	$0

Furthermore, unlike FHA loans and other low-down-payment mortgages, there is no private mortgage insurance (PMI) requirement with a VA loan. Not having to pay PMI won't help you with the up-front costs of purchasing a home, but it will help significantly with your monthly cash flow and will also decrease the long-term cost of owning your home.

Unique Benefits Bring Unique DisadvantagesUnfortunately, VA loans aren't available to everyone. They're limited to eligible veterans, active duty, reservists and National Guard members, and some surviving spouses, all of whom must prove that they're qualified by obtaining a certificate of eligibility from the VA (the lender can often complete this step for the borrower). You can learn more about who is eligible at the United States Department of Veterans Affairs website.

VA loans are only allowed for owner-occupied primary residences, so don't plan to use one if you’re looking to finance an investment or vacation property. Also, lenders won't finance VA construction loans according to the book Your Guide to VA Loans by David Reed.

Perhaps the biggest disadvantage of a VA loan for those who are eligible is that it requires a funding fee. For homebuyers taking out a VA loan for the first time and not making a down payment, the funding fee is 2.15% of the loan amount for regular military veterans, and 2.4% for members of the reserves or National Guard. If it's not your first time using your VA entitlement, the funding fee jumps to 3.3%. Since this cost is a fee, it doesn't contribute to your home equity. It is essentially a closing cost. The VA uses these funding fees to help pay the guarantees on VA loans that go bad.

Few people will be exempt from the funding fee. Borrowers who don't want to pay for it can try asking the seller to pay it, just like they might ask the seller to pay any other closing cost. It's also possible to roll the funding fee into the loan, which is a good short-term solution for cash-strapped buyers but a bad long-term solution because then the borrower must pay interest on the funding fee for the life of the loan.

VA Vs. FHA Vs. ConventionalBecause they are the two lowest down-payment options available, many borrowers who are eligible for VA loans might also be considering FHA loans - a loan insured by the Federal Housing Administration. If you qualify for both, which one should you choose and why? (Learn more in Buying A Home: Get Preapproved For A Loan.)

Watch: Mortgage Basics

FHA mortgages require a fee similar to the VA loan's funding fee. It's called up-front mortgage insurance and it costs 2.25% of the loan amount as of May 2010. FHA mortgages also require borrowers to pay monthly private mortgage insurance at a rate of about 0.5% annually of the loan amount until the borrower accumulates 22% equity.

On a $200,000 house, then, an FHA loan would require you to put down $7,000, pay a fee of $4,243.50 (0.0225 x $193,000), and pay an additional $965 (.005 x $193,000) a year for PMI. If you rolled that funding fee into your loan, your monthly mortgage payment and PMI would go up slightly.

A VA loan, on the other hand, would require $0 down, a fee of $4,300 to $4,800, and no PMI. If the interest rate on your mortgage was 6% and your term was 30 years, your monthly principal and interest on the FHA loan of $193,000 would be $1,157.13; on the VA loan of $200,000, it would be $1,199.10, a difference of $41.97 a month or $503.64 a year.

If you have a significant down payment, your best option might be a conventional mortgage. You'll avoid the funding fee of 1.25% to 1.5% that the VA charges even when borrowers have a down payment of 10% or more. On a $200,000 home with a 10% down payment, the VA's funding fee would be $2,250 or $2,700 (.0125 x $180,000 or .015 x $180,000).

ConclusionDespite the funding fee, the lack of a down payment requirement and PMI make VA loans a very attractive option for qualified homebuyers.
by Amy Fontinelle (Contact Author | Biography)

Amy Fontinelle is a financial journalist and editor for a variety of websites, public policy organizations, and book publishers. She has written hundreds of published articles and blog posts on topics including budgeting, credit management, real estate and investing. Her articles have been featured on the homepage of Yahoo! and on Yahoo! Finance, Forbes.com, SFGate.com and numerous local news websites.

Filed Under: Home Insurance, Mortgages

Reverse Mortgage Pitfalls

Filed Under: Credit Cards, Insurance, Mortgages, Real Estate, Retirement

Reverse mortgages are a way for elderly people to draw an income (either in installments or a lump sum) against the equity that they've built up in their homes. For many older people in need of funds to live on, it is nothing short of a blessing, but there are some pitfalls to the process that everyone should consider. Find out what you need to know before taking the plunge. (For further reading on reverse mortgages, see The Reverse Mortgage: A Retirement Tool.)

High CostsAlthough an individual is technically tapping the equity on his or her own house, the bank charges a fee to initiate the transaction. In fact, according to ReverseMortgage.Org, as part of a reverse mortgage, homeowners may be required to pay an origination fee of $2,000 or 2% of the loan amount, whichever is higher. Some homeowners choose to fold this fee into the loan and pay it back over time with interest.

In addition, there are other fees that homeowners may be responsible for, such as an appraisal fee, which can range in the hundreds of dollars, a recording and credit report fee, which tends to be about $200, and a pest inspection and a flood certification fee, which are about $150 (for both). Finally, homeowners may also be asked to get mortgage insurance, and may be charged a flat monthly account "service fee", which can range from $30 to $35 a month. In short, the costs associated with a reverse mortgage can initially nibble away at the income you'll receive.

Homeowners in need of liquidity who are considering selling their homes within the next several years would probably be better off applying for a more traditional line of credit, a home-equity loan or a personal loan, given the large upfront costs associated with the process. (To learn more about home equity loans, see Home-Equity Loans: The Costs and The Home-Equity Loan: What It Is And How It Works.)

Your Kids Might Not Inherit the Family HomeParents may like to pass the family home onto the next generation. However, when a reverse mortgage is taken out, even though the lending institution does not take title to the home, the mortgagee has an obligation to pay back the loan over time with interest. In many cases, that repayment is made by selling the home and then turning over the proceeds (or a portion of them) to the bank.

As a possible workaround to avoid selling the family home, some families will take out an insurance policy on the homeowner and then make an adult child or the lending institution the beneficiary. Using this strategy, the bank may be repaid without having to sell the property upon the homeowner's death. Consider consulting with an insurance agent to determine the best way to ensure that proceeds from such a policy are sufficient enough to satisfy the outstanding loan.

Impact on Future FinancingWhen an individual initiates a reverse mortgage, he or she is creating a huge liability because the loan must be repaid with interest. However, many individuals do not realize that establishing a reverse mortgage may jeopardize their ability to obtain financing at a later date.

On the surface, this may not seem like a concern for elderly homeowners given that they are unlikely to buy another home or make a sizable purchase, but it can have an adverse impact on applications for car and personal loans. It may also impact a homeowner's ability to acquire credit cards.
Reverse Mortgages May Impact Medicaid BenefitsLending institutions are quick to say that obtaining a reverse mortgage will not affect one's Medicaid payments, but according to RateEmpire.com a site dedicated to lending sources, education and information, "if you receive Medicaid, any reverse mortgage proceeds that you take delivery of must be utilized right away." More specifically, the site says that any retained funds "will count as an asset and may affect your Medicaid eligibility." In other words, this means that if you were to receive $10,000 in a lump sum, you would have to spend that money shortly after receiving it. If you fail to do this, any money left over may count as an asset for Medicated eligibility purposes.

RateEmpire also states that if the total liquid resources are more than $2,000 for an individual or $3,000 for a couple, this could make the person ineligible for Medicaid.

Individuals currently receiving or anticipate receiving Medicaid should consult an accountant and a financial advisor in order to make certain that they are aware of all of the potential ramifications of taking out a reverse mortgage. (To learn more about Medicaid and long-term care, see Medicaid Versus LTC Insurance, Failing Health Could Drain Your Retirement Savings and Long-Term Care: More Than Just a Nursing Home)

Potentially Unfavorable TermsWhile the lending institution may neither go after your heirs for money, nor are they entitled to take more than the appraised value of your home, there are several items usually located in the fine print of these contracts that can be disturbing.

For example, some reverse mortgages have clauses that state that the loan must be repaid if the home is unoccupied for a certain period of time. This means that the homeowner could (hypothetically) be in the hospital receiving treatment for a medical condition, and be released to find that their home is in foreclosure.
Furthermore, because homeowners remain responsible for all taxes, insurance and upkeep on the home, failure to pay taxes or maintain adequate insurance could cause the loan to be called.

Keep in mind that the property is also subject to an appraisal. So, while you might have put a large amount of money into your home over the years, there is the chance that it's worth less than you paid. This means that the proceeds that you receive as part of the reverse mortgage process may be less than what you might have anticipated.

Bottom LineReverse mortgages are a great way for people to tap the equity in their homes, either in installments or in a lump sum. However, be aware of the potential downsides to entering into such an agreement. (To find out more, check out Is A Reverse Mortgage Right For You?)
by Glenn Curtis (Contact Author | Biography)

Glenn Curtis started his career as an equity analyst at Cantone Research, a New Jersey-based regional brokerage firm. He has since worked as an equity analyst and a financial writer at a number of print/web publications and brokerage firms including Registered Representative Magazine, Advanced Trading Magazine, Worldlyinvestor.com, RealMoney.com, TheStreet.com and Prudential Securities. Curtis has also held Series 6,7,24 and 63 securities licenses.

Filed Under: Credit Cards, Insurance, Mortgages, Real Estate, Retirement

Buzz up!

Remodeling The Housing Finance Industry

Filed Under: Mortgages, Real Estate

History suggests that Fannie Mae (FNMA) and Freddie Mac (FHMLC), along with the less popular Government National Mortgage Association (GNMA) and Federal Home Loan Banks (FHLB), should have limited-life charters as government-sponsored enterprises (GSEs). These GSEs were created by the United States government to respond to specific problems in the housing finance markets that existed at certain times.

However, these organizations continue to exist - and there's some dispute as to whether this is a good thing. Here we'll look at how the current system came about as well as what the future holds for housing finance. (Looking to buy? Check out Top Tips For First-Time Home Buyers.)

In the BeginningFannie Mae was created in response to the Great Depression when the economy made it difficult for homeowners to meet mortgage terms. Fannie Mae purchased and securitized Federal Housing Administration (FHA) and Veteran's Administration (VA) mortgages to inject liquidity into the mortgage markets. GNMA, or Ginnie Mae, was created thereafter to guarantee receipt of principal and interest payments on securitized loans. Freddie Mac was created along with GNMA to provide another type of securitization further enhancing liquidity. Similarly, Federal Home Loan Banks were created to provide liquidity directly to lending institutions that fund mortgage loans. Once these problems were effectively solved and the goals were achieved, government-sponsored enterprises should have continues as wholly private businesses without the special privileges afforded by government charter status.

Balancing Risk and RewardWhat is the rationale behind limited-life charters for GSEs? Simply put, the primary goal is to facilitate privatization and increase competition in the secondary mortgage market. One of the primary structural problems with GSEs is the risk-reward balance. With the exception of contributions to affordable housing initiatives, the government has minimal share in the profits of GSEs while bearing the majority of risk associated with maintaining their existence. (Find out what went wrong with this set-up in Who Is To Blame For The Subprime Crisis?)

This risk is ultimately absorbed by taxpayers who fund the government that charters and supports these GSEs. Privatization shifts risk management back to shareholders and managers of GSEs, and away from taxpayers, legislators and government bureaucrats. Engaging in business activities that produce revenues and profits, instead of relying on legislation to ensure funding guarantees, will ensure survival of individual companies and draw new companies into the market mix that will guarantee the long-term survival of the housing finance industry. (To learn more about the benefits of privatization, take a look at Why Public Companies Go Private.)

Limited but Proactive ApproachPrevious markets were characterized by residential mortgage backed securities (MBS), a type of security that relied on the past trend of rapidly increasing house values and income generated from high interest rate mortgages. Throughout the history of U.S. real estate lending, the government as well as private companies in the market adjusted to change by modifying their products and services. Through legislation, the government modified institutions like FNMA, FHLMC and GNMA to provide liquidity and availability of funds to private lenders. Meanwhile, private lenders modified underwriting guidelines and created designer loan products to meet and/or create greater demand for residential mortgage loans. (Learn about one of the factors behind housing prices in How Interest Rates Affect The Housing Market.)

The conservatorship of Fannie Mae and Freddie Mac in 2008 was a critical and essential strategy for solving the specific housing and mortgage problems that have prevailed through the early 21st century. The terms of conservatorship allow Fannie and Freddie to continue extending mortgage loan guarantees, but limit their investment activities in purchasing and holding loans in a portfolio. Instead, the U.S. Treasury will directly purchase more mortgage-backed securities. This step does something to spread the risks associated with investing in the housing market and related securities, but is insufficient without strategies to support private sector activities and investments.

Future TrendsWhat does the future hold for the mortgage industry and the secondary mortgage market? Even with the housing and mortgage crisis that has lasted through the first decade of the 21st century, financial creativity will not cease. Rather investors will focus less on direct investment in residential mortgages and more on activities including land acquisition, real estate development, construction and commercial lending. This change should neither hinder the path to homeownership nor reduce homeownership rates. It will, however, change the nature and landscape of homeownership. As a result, the new path to homeownership may be characterized by various rent-to-own or lease-purchase options as a prerequisite qualification for mortgage borrowers. (Learn about some of the issues in Rent-To-Own Real Estate Full Of Pitfalls.)

Why is this a necessary consideration? Availability of consumer and residential mortgage credit will continue to decline, or at least will not increase in the first few years of the second decade of the 21st century. Subprime loans with low to no down payment requirements will be difficult for buyers to come by with even the best credit and income. Those with marginal credit and income histories will be even further affected. Rent or lease options may be used to satisfy the down payment requirements associated with historical and re-emerging mortgage loans requiring as much as 20% down payments.

What Does It Mean for Investors?How does this affect investors? Simply by changing the underlying assets that make up the securities they invest in. Investment in credit obligations will be “secured” by corporate cash flows based on business activity derived from receiving rental payments from home buyers instead of relying solely on individual consumers' ability and willingness to repay high rate mortgage loans.

Customized Service
Why does this work better than direct-to-consumer mortgage lending? When an individual borrower defaults on a mortgage loan, the lender's only option is foreclosure on the property. The lender cannot step in and manage the borrower in a way that can produce income to help the borrower keep up with the mortgage payments. (Foreclosure is not always bad for investors. Learn more in Foreclosure Opens Doors For Real Estate Investors.)

However, an investor in corporate securities could effectively assume and manage the business operations in a manner that could increase revenues and cash flows. Investors will invest in companies that earn revenue and cash flow from business activities that create stable homeownership opportunities. This does not completely eliminate the residential mortgage loan, but will redirect the borrowing process in a way that will diminish some of the detrimental risk associated with subprime lending and mortgage derivative securities.   

The Final AnalysisIf history has taught us anything, it' that housing and homeownership are staples of the U.S. economy and way of life. Both public and private sectors will continue to play a critical role in maintaining the housing finance industry. Government sponsored enterprises were created and exist to solve current problems in the housing and mortgage finance markets. Private businesses and corporations exist to maintain the markets once these issues are addressed.

As housing prices have declined and the greater economy has suffered, the government has spent the early part of the 21st century finding solutions to the total of economic concerns that accompany declines in the housing finance markets. However, the ball will soon be back in the private sector's court. The businesses that survive the next phase of transition in the housing and mortgage industry will be those that focus on developing new and non-traditional paths to homeownership as opposed to simply creating new forms of mortgage securities to sell in the secondary markets. (There are many ways to get into the housing market. Learn about them in Simple Ways To Invest In Real Estate.)

Learn more about these GSE's in How Fannie Mae And Freddie Mac Were Saved and Fannie Mae, Freddie Mac And The Credit Crisis of 2008.
by Denise Finney (Contact Author | Biography)

Denise Finney started her career with an investment company. She has worked extensively as a financial trainer, consultant and coach; conducting seminars on personal financial planning, as well as working one on one with people and families helping them to manage their financial lives.

Finney is a mortgage industry veteran, having worked in both commercial and residential lending as an originator, wholesale lending executive and licensed mortgage broker in Ohio. At this time, Finney is a consultant and freelance writer.

Filed Under: Mortgages, Real Estate

Self Employed? 5 Steps To Scoring A Mortgage

Filed Under: Credit, Credit Cards, Credit Report, Insurance, Loans, Mortgages, Options, Personal Finance, Real Estate

While getting a loan as a W-2 employee may be cheaper and easier than if you're self-employed, you don't have to go running back to your cubicle to qualify for a mortgage. Some lenders may be concerned that you won't earn a steady enough income to make your monthly payments, and others may simply not want to deal with the additional paperwork that can be involved in providing a mortgage to a self-employed person. But don't worry; if you're self-employed, there are mortgage products available as well as steps you can take to make yourself a more attractive loan candidate.

What to Expect
As someone who is self-employed, lenders may not see you as the ideal borrower. Expect to pay higher interest rates than the ones commonly advertised on mortgage websites; those rates are for prime borrowers, or borrowers who are considered to be particularly creditworthy because of their steady, verifiable incomes and excellent credit scores. Similarly, because you may be a less attractive candidate, you might have a reduced ability to shop around and negotiate a lower interest rate. You may also have to put more work into finding lenders who are willing to work with you in the first place. (For more, see The Importance Of Your Credit Rating.)

Another problem you may encounter is that if you've used lots of business expenses to reduce your taxable income on your tax returns, lenders may wonder if you make enough money to afford a home. Finally, banks may want to see a lower loan-to-value ratio (LTV ratio), meaning that you'll need to come up with a larger down payment.
Mortgage OptionsDue to the subprime mortgage crisis, it may become more difficult for the self-employed to obtain mortgages as banks shy away from riskier investments to protect their financial interests and their reputations. (To find out more, see Who Is To Blame For The Subprime Crisis? and The Fuel That Fed The Subprime Meltdown.)

However, some lenders may still be willing to give you one of the following types of loans.

• Stated Income/Stated Asset Mortgage (SISA) 
  This type of mortgage is based on what you tell the bank your income is; the bank will not seek to verify this amount. Stated income loans are sometimes also called low-documentation loans; this is because while lenders will not verify how much you make, they may seek to verify the sources of your income. Be prepared to provide a list of your recent clients and any other sources of cash flow, such as income-producing investments. The bank may also want you to submit an IRS Form 4506 or 8821. Form 4506 is used to request a copy of your tax return directly from the IRS, thus preventing you from submitting falsified returns to the mortgage company, and costs $39 per return. But you may be able to request Form 4506-T for free. Form 8821 authorizes your lender to go to any IRS office and examine the forms you designate for the years you specify. This service is free.
  
  
• No Documentation Loan In this type of loan, the lender will not seek to verify any of your income information. This may be a good option if your tax returns show a business loss or a very low profit. Because it is riskier for the bank to lend money to someone with an unverified income, expect your mortgage interest rate to be higher with either of these types of loans than with a full-documentation loan. Low and no documentation loans are called Alt-A mortgages, and they fall between prime and subprime loans in terms of interest rates. For lenders, they are considered more risky than prime loans, but less risky than subprime loans.

While many self-employed individuals and couples may choose one of the above options due to the difficulty of sufficiently documenting their incomes, those who can prove their incomes and who are willing to submit the extra paperwork can still apply for full-documentation loans, which will have lower interest rates than their low- and no-doc cousins. While a traditional employee might simply need to provide copies of W-2s for the last two years, because self-employed individuals do not receive this document, they may need to provide information about their businesses, such as previous years' tax returns, a current business license, a signed statement from an accountant, profit and loss statements, and balance sheets.

Getting a joint mortgage with a co-borrower who is a W-2 employee, such as a significant other, spouse, or trusted friend, is another way to improve your prospects of getting approved for a mortgage if you are self-employed. This provides more assurance to your lender that there is a steady income to pay back the debt.
Finally, a parent or other relative might be willing to cosign your mortgage loan. Keep in mind that this person will need to be willing and able to assume full responsibility for the loan if you default.
Can You Really Afford It?
It can be easy to get into trouble with low- and no-documentation loans because it's easy to fudge the numbers. Realize that you, not the bank, know best about whether you can really afford the loan, and that you will be the one who truly suffers if you lose your home. Learn from the experiences of all the subprime borrowers who have gone into foreclosure and don't get in over your head. (For more insight, read Mortgages: How Much Can You Afford?)

Make Yourself an Attractive CandidateIf you know you can make the payments, you can do some of the following things to improve your chances of getting a loan.

1. Max Out Your Credit Score
   In any type of borrowing situation, a higher credit score will make you a more attractive candidate to get the loan in the first place and to qualify for lower interest rates if you're approved. (For more insight, read Five Keys To Unlocking A Better Credit Score.)
   
2. Offer a Large Down Payment The higher your equity in the home, the less likely you are to walk away from it in times of financial strain. Therefore, the bank will see you as less of a risk if you put lots of cash into your purchase up front.
   
3. Have Significant Cash ReservesIn addition to a large down payment, having plenty of money in an emergency fund shows lenders that even if your business takes a nosedive, you'll be able to keep making your monthly payments. (Find out how in Build Yourself An Emergency Fund.)
   
4. Pay Off All Your Consumer Debt
   The fewer monthly debt payments you have going into the mortgage process, the easier it will be for you to make your mortgage payments. If you pay off your credit cards and car loans, you may even qualify for a higher loan amount because you'll have more cash flow. (Check out, Digging Out Of Personal Debt.)
   
5. Have an Established Track Record of Self-Employment
   If you can show that you know how to play the self-employment game and win, lenders will be more willing to take a chance on you. Some advice suggests that you should have at least two years of self-employment history; other advice, however, says that when interest rates are low, you should try to get a mortgage as soon as you're ready, even if you don't have a long history of successful self-employment.
   
6. Be Willing to Provide Documentation
   Being willing to fully document your income through previous years' tax returns, profit and loss statements, balance sheets and the like will increase your chances of qualifying for a loan.

Conclusion
If a W-2 employee loses his or her job, the person's income will drop to zero in the blink of an eye in the absence of unemployment insurance benefits; those who are self-employed often have multiple clients and are unlikely to lose all of them at once, giving them more job security than is commonly perceived. Of course, if you're self-employed, you're already used to having to work extra hard to file additional tax forms, secure business licenses, get new clients and keep your business running. Don't let anyone tell you that you'll never get a mortgage if you're self-employed, or that you shouldn't quit your day job to pursue your dream of running your own business until you've already purchased a home. Armed with a little knowledge and patience, you'll be able to have your own home and work in it, too.

by Amy Fontinelle (Contact Author | Biography)

Amy Fontinelle is a financial journalist and editor for a variety of websites, public policy organizations, and book publishers. She has written hundreds of published articles and blog posts on topics including budgeting, credit management, real estate and investing. Her articles have been featured on the homepage of Yahoo! and on Yahoo! Finance, Forbes.com, SFGate.com and numerous local news websites.

Filed Under: Credit, Credit Cards, Credit Report, Insurance, Loans, Mortgages, Options, Personal Finance, Real Estate