The Best Rate Is Not Always the Best Advice

Kim and me celebrating the closing of our new home.

The photograph accompanying this article was taken at the closing of our new home.

Kim and I were genuinely happy. We had found a house that worked well for our family, successfully navigated the purchase and finally reached the point where we could celebrate.

But a great deal of work happened between finding the house and raising those glasses.

There were inspections, negotiations, documents, decisions about our existing home and, of course, the mortgage. One of the most important tasks was finding a mortgage that fit our specific plans - not simply the one with the most attractive advertised rate.

During that process, I received two recommendations that initially sounded very appealing.

One promised a significantly lower mortgage rate.

The other offered a mortgage discount and "more investment options."

Either recommendation might have been perfectly reasonable for someone else. But after I looked at how each one interacted with the rest of our financial plan, neither was right for us.

Good financial advice cannot be evaluated one product at a time.

The mortgage offer that sounded too good to pass up

As we prepared to purchase our new home, I explained our plan to a mortgage broker.

We expected to buy the new house before selling our existing home. Once the old house sold, we wanted to apply a substantial portion of the proceeds to the new mortgage and then, if permitted, recast the loan.

A mortgage recast generally works like this: You make a significant payment toward the principal of an existing mortgage. The lender then recalculates, or re-amortizes, your monthly principal-and-interest payment using the lower outstanding balance, the existing interest rate and the remaining term of the loan. Unlike refinancing, a recast generally does not replace the existing mortgage or change its interest rate. Its primary purpose is to reduce the required monthly payment after a large principal payment. Not every mortgage is eligible, and lenders may impose minimum-payment, timing and fee requirements.1

The broker knew that this was our plan.

She offered us a rate similar to the other rates we had received, but with an additional incentive: during the first year, our effective rate would be reduced by one percentage point.

A full percentage point sounded enormous.

I was excited.

During the conversation, I also asked about a fee of approximately $1,000. She told me not to worry about it because she would give us a credit. She explained that the lender would compensate her for originating the mortgage and that, because ours would be a relatively large loan, she could use part of that compensation to cover the fee.

I appreciated her transparency, but the conversation made me curious. If there was enough compensation available to absorb the fee, I wanted to understand the complete economics of the offer.

So I kept asking questions.

Eventually, I learned that under the promotional terms as they were explained to me, we would not be able to make the substantial additional principal payment we were planning during the one-year promotional period.

That changed everything.

I ran the numbers based on our expected home-sale proceeds and the timing of our planned principal payment. The value of applying that money to the mortgage - and avoiding interest on that portion of the balance - was substantially greater than the benefit of the temporary one-percentage-point reduction.

It was not particularly close.

The headline rate was better.

The overall financial outcome was worse.

To be clear, I am not suggesting that the broker was intentionally trying to give us bad advice. It is possible she had not fully considered how the restriction would affect our particular strategy.

But I had explained what we intended to do.

The recommendation focused on helping us obtain a mortgage. It did not fully account for what we planned to do after closing.

There was also an unavoidable conflict: if we selected another lender, she would not be compensated for the transaction.

That does not make her dishonest or the mortgage inherently bad. It simply means that her role, incentives and scope were different from those of someone we might hire specifically to evaluate the decision within our complete financial plan.

The retirement rollover that could have closed another door

The second recommendation came from a representative of a national bank.

After learning that I still had money in my former employer's 401(k), he suggested rolling it into an Individual Retirement Account (IRA) at the bank. He explained that an IRA would offer more investment choices and that moving the assets could qualify us for a relationship-based mortgage-rate discount.

Again, the offer sounded attractive.

But I use a strategy commonly called a backdoor Roth IRA. It involves making an after-tax contribution to a traditional IRA and then converting it to a Roth IRA.

The strategy becomes more complicated when someone has other pre-tax IRA money. Under what is commonly called the pro-rata rule, the Internal Revenue Service (IRS) generally looks at a person's combined traditional, SEP and SIMPLE IRA balances when determining how much of a Roth conversion is taxable.2

If I had rolled my large pre-tax 401(k) balance into an IRA, most of my future backdoor Roth conversions could have become taxable. The rollover would not have made the strategy impossible, but it could have made it substantially less tax-efficient and more difficult to manage.

A recommendation intended to give me "more investment options" could have complicated one of the useful planning tools already in my toolbox.

Once again, I do not believe the bank representative was trying to harm us. He may not have known that I used this strategy because he had never examined our complete financial picture.

He was explaining the benefits of his bank's products. But if we obtained the mortgage elsewhere, he would not receive credit for originating our loan.

That did not automatically make his recommendation wrong.

It meant that I needed to evaluate it in context.

A good product can still be wrong for you

Both professionals presented legitimate potential benefits:

·         A temporary mortgage-rate reduction

·         A credit toward a loan fee

·         A relationship-based mortgage discount

·         A broader selection of investments

The problem was not that those benefits were imaginary. The problem was that they were presented without fully considering how the decisions would affect the rest of our plan.

The mortgage offer did not adequately account for our planned principal payment and recast.

The rollover recommendation did not account for my backdoor Roth IRA strategy or the other differences between retaining an employer plan and moving the money into an IRA.

Each recommendation made sense through the lens of the product being offered.

Neither professional had been engaged to examine our entire financial picture.

What does it mean to work with a fiduciary

"Fiduciary" is a word that is used frequently in financial services, sometimes without much explanation.

In general, an investment adviser providing advisory services must act in the client's best interest and not place the adviser's interests ahead of the client's. Material conflicts of interest must also be disclosed.3

That does not mean a fiduciary will always be right - or that professionals who are paid through commissions are dishonest.

The difference is often the scope of the assignment.

A mortgage professional may be focused on helping you obtain a mortgage. A bank representative may explain the advantages of the bank's products. A fiduciary financial planner can be engaged to examine how a recommendation affects your taxes, investments, retirement accounts, liquidity and long-term goals.  Of course, fiduciary advice has limits: it involves a fee, depends on complete information and cannot guarantee a better outcome.

The question is not simply whether the product has benefits.

It is whether those benefits still make sense when viewed as part of your complete financial plan.

Paying for advice can create a different relationship

Many people hesitate to pay directly for financial advice. I understand why: a planning fee is visible, while commissions, product expenses and lost planning opportunities can be much harder to see.

But not receiving a separate invoice does not tell you how the professional is compensated or what incentives may influence the recommendation.

A financial planner can be paid to evaluate the decision itself - not to complete a mortgage, rollover or product sale.

The value is not simply having someone else perform the arithmetic. It is having someone examine how the decision affects the rest of your financial life before you make a choice that may be difficult to reverse.

In our case, a few additional questions changed how we viewed two attractive offers.

The lower rate was not necessarily the better mortgage.

The larger investment menu was not necessarily the better retirement decision.

And the person offering the product was not necessarily the person best positioned to determine whether it fit our plan.

The most important question was not:

What benefits does this product offer?

It was:

What happens to the rest of my financial plan if I say yes?

Sources

1. Fannie Mae, Re-amortized Recast Mortgages

2. Internal Revenue Service, Instructions for Form 8606

3. U.S. Securities and Exchange Commission, Investor.gov, Investment Advisers

Disclosure

Investment advisory services offered through Fiduciary Financial Advisors a registered investment adviser. The views expressed represent the opinion of Fiduciary Financial Advisors. Information does not constitute investment, tax, or legal advice.