So You Want To Buy A House

As I've mentioned before, most of the topics I write about in this blog come from the casual (and sometimes not so casual) questions people ask me every day. One of the big topics lately has been buying a home. You'd think that with all of the pressure on Americans to buy their own homes, we would feel a little more comfortable with the mechanics of it. But most of us end up confused or frustrated at some point in the process. To help prevent that, here are a few things to think about if you are considering a new home.

It's your life

Let's start with the obvious. Some of us buy because we are dreaming of that home. Some of us, though, are just feeling like buying is something we are supposed to do. Yes, a home can be a great investment, but like all investments it can go really badly. Before you buy for investment purposes read this post.

Likewise, buying can make you feel more grown up if your idea of dinner at home is a take out carton and a coffee table you picked up on Craiglist. But homeownership is a pretty expensive way to impersonate a grown up. If you are thinking of spending hundreds of thousands dollars to buy a new place, make sure it's a decision that works for you. Put aside any and all advice from well-meaning family, friends and real estate agents and really weigh whether at this particular point in your life (whenever that is) you actually want to be a homeowner. If the thrills of home decorating don't make up for the frustrations of home maintenance for you, maybe you'd be better off getting a real kitchen table and throwing the extra money in your retirement account. If you do want to be a homeowner...

Do the math

There are a thousand and one mortgage calculators on the web to help you figure out how much you would pay per month and in down payment for the house of your dreams (or a smaller replica of the house of your dreams). I've already posted a basic explanation of how banks calculate your mortgage qualifications.

But it isn't just about what you can afford. Be sure to think about the what you actually want to pay given your other monthly expenses and opportunities. Mortgage payments, like rent payments, fit into the category of "fixed expenses," the things that you can't negotiate if you have a difficult month. It's one thing to cut out the fine dining, put off a trip or cut down on your retirement contributions for a bit; it's a whole other thing to be tied to a high mortgage payment if your income suddenly goes down. Which means you want to do some real soul searching about how much of a mortgage payment you are ready to carry, no matter what happens.

Not So Hidden Costs

We all know there are extra expenses to buying a home, but they look pretty inconsequential next to the home prices themselves. They seem a lot less inconsequential on closing day when you actually start to pay them. From the beginning of your search, keep this list in mind and be ready with cash on hand. And of course, bargain with everyone from banks to sellers for the best deal.

The first of the "extra" costs is the real estate agent's commission  (typically 6% split between the seller and the buyer agents). If you are smart, you'll also pony up for a home inspector whom you trust—you will feel pretty stupid if you scrimp on the few hundred bucks here and find yourself with thousands of dollars in surprise repairs later.

And then there are the famous "closing costs" that come due on the day you get the keys for your new house. In total closing costs generally range from about 2% to 5% of the value of the property, though it's not unheard of to see that percentage go all the way up toward 8% (ouch).

• Bank Fees (the bank giving you the mortgage may charge an origination fee, "discount points", credit report or loan application fees, title search and title insurance fees, a charge for the appraisal, and the initial interest payment)
• Initial property tax payment
• Charge for a survey of the property
• Homeowners Insurance
• Attorney fees (for your attorney)
• Recording fee (to your local government records office when you file your new title)

Your closing costs will be lower if you get tough with your lender from the start (be sure to ask the bank for a Good Faith Estimate—they are required to give it to you by law!). Costs can be shared with the seller if you and your agent negotiate well, and if you've got a little extra room in your mortgage limits, some of these costs can be rolled into your mortgage. This is the place where having a good agent and communicating well with your bank can make a huge difference.

Don't Rush the Process

In all likelihood, you won't end up buying the first home you think you want. Plan to spend at least 3-4 months becoming familiar with the market and just as importantly, focusing in on what you really want. Real estate agents are notorious for bringing clients to homes that only loosely fit the client's "wish list." It's not that your agent wasn't listening to you; it's just that agents have learned from experience that most people only realize what matters to them most by looking at a lot of different properties and changing their minds over time.

Patience can save you money on your home price. And it can save you money after closing. The adrenaline rush of buying a house tends to send new owners into a follow-up frenzy of furniture shopping and DIY projects. This is all made worse by the fact that the $6,000 dining table no longer looks as expensive when compared with the $600,000 condo. By all means, pick up a new couch if you don't have one from your old place. But you'll save money and be happier with your home in the long run if fill in the gaps slowly (or at least wait until $6,000 looks like a big number again).

Ask Around

At this point it might look like I am trying to dissuade anyone from buying a home. I'm not. Buying a home is an exciting process. If this is the next big purchase for you, start by asking people you know about their own experiences. How was their lender? Who was their agent? Their home inspector? Which areas of town did they search? Why did they buy where they did? What would they have done differently, if anything?

The home hunting season starts up in late February. Good luck!

How Much Money Should I Have Before I Need Advice?

I get this question all of the time. And I understand why. The whole "investment" thing, heck, even the financial planning concept, seems designed for people who aren't worried about whether they'll have to wait until next month to fix the muffler on the aging Honda. Actually, though, this is the wrong question. The right question isn't about how much money you have; it's about how much time you have to grow it. Let me explain...

Imagine a woman who's doing quite well for herself. She's got a good career, saves up a little money every month, and just received a big bonus at work. All of the sudden, she has $120,000 in her bank account. Does she need investment advice? Well, maybe not. Let's say now that what she really wants to do is to buy a house in her favorite neighborhood with her savings. Since she lives in the Boston area, that's going to be about $650,000 (no, really). And she wants to do this within the next 3 years.

This would be a great time for her to pay for a financial plan—she's going to want to think about how the mortgage terms play with her other financial goals, taxes, retirement savings, etc... But if she plans to put all of her money into real estate within the next few years, actual investment advice is pointless. The best she can do is probably an FDIC insured bank account with some sort of interest rate (better yet, at her local credit union to set herself up for more favorable mortgage terms).

Sure, she could put the money in the stock market or into bonds or other investments for the next few years, but no financial advisor worth her salt would recommend it. Why? Because investment in securities (stocks, bonds, funds, private businesses, etc...) works well for the long-term. In the short-term, though, investments are a lot more risky and a lot less likely to be worth the hassle and expense. If the market or business is "down" when the perfect property comes up, she's out of luck.

Now imagine another scenario. Like the first woman, this other woman is on the right track after overcoming some difficulties. She's got nothing in the bank, yet, aside from some emergency funds (and we don't ever want to invest those!). On the other hand, she wants to start putting money away for sometime down the road. She's only going to be able to put aside $50 a month for right now. But she has no intention of touching that money for the next 8 to 10 years, at least. Does she need investment advice? Absolutely.

Thanks to all sorts of affordable investments and investment accounts, she's got a ton of choices in terms of where her money goes. Maybe she needs some sort of tax deferred retirement account. Maybe she'd be better off not deferring the taxes. Maybe she needs one well-managed fund, but which kind of fund works best? How can she avoid unnecessary fees? Sure, she is starting small, but the choices she makes now will have a big impact on how that money grows—or doesn't.

So, don't ask yourself (or your local advisor) how much money do you need before you should get investment advice. Ask yourself what your time frame is for that money. If you've got it for 2-5 years, you should probably be shopping for good deals at your local credit union or bank. If you feel confident that you won't be touching it for at least 5, or better yet, 10 years, it doesn't matter what you've got—it's time to become an investor.

Is Your House A Home Or An Investment?

Ask this question of just about any American and they will happily tell you that it is both. And why not? From home improvement centers and real estate agents to government programs and tax breaks, the clear message is that it is always better in the U.S. to own a home. The reality is a little trickier, though. And if you plan to use your home as an investment—that is, to actually get additional value out of it at some point in the future—you need to think more clearly about the limitations of living in one of your biggest savings accounts. Here are a few key points to consider:

1. You don't buy a house for the land.

We have a tendency to think that buying a house is somehow a more "stable" investment, as if the fact that we can still touch and see the land means that it's value is not going anywhere. Sure, you can probably still grow potatoes on the land  even if the economy tanks. But let's face it, you didn't pay a quarter of a million dollars so you could grow veggies and no one else is going to either. The value of property, like the value of any other investment, comes from only one factor—what someone else will pay for it at the moment you want to sell;

2. Home values can be just as unstable as stock markets.

Our most recent U.S. Census data shows that median household net worth went up by about 30% between 2000 and 2005 (an increase from $81,821 to $106,585)! This was great news, and it was almost entirely due to the fact that people's home values went up during those years. But when home prices dropped in the 2008 crash, Americans' net value also went down...by about 35% as of 2011. That crash wiped out almost a decade worth of gains, and it left many homeowners with mortgages that were more than the home's value. We haven't all recovered, yet. According to Zillow's 2014 report, 16.9% of U.S. homes were still "underwater" (worth less than their home loans) as of the end of October, 2014. Which brings me to my next point—

3. You can't live in a mutual fund.

Generally speaking, this is a point in favor of buying a home as an investment. Since you were going to pay housing costs anyway, why not put it toward an asset of your own? But if your stock prices crash, you can usually leave them be and wait it out until the market recovers. If your home price crashes and you can't afford your mortgage or you have to move for a new job, you just don't have that luxury. That means you may be forced to "cash in" at the worst possible time, making you a lot more vulnerable to losing all of that money you've put in and possibly more;

4. Your mortgage is someone else's investment.

In our rush to celebrate the great American home-buying dream, we often forget that the reason economists love home buyers is because home owners borrow so much money. Home owners not only tend to take out large mortgages (which can be bundled and sold off into all sorts of investments by financiers), they also borrow more through auto loans, education loans and credit cards because of the sense of safety provided by their home values. It's great for the economy, but it might not be so great for you. If we assume that the average U.S. mortgage is a 30-year fixed rate at about 4.5% interest on a $222,000 loan, then the average home owner is paying a total of about $183,000 in interest for the privilege of being rent-free. This, of course, does not include any of the closing costs, maintenance, taxes and upgrades you choose to do on your home (not to mention the added temptation of new sofa cushions, shelving, curtains, etc...);

5. There's no profit until you sell.

All of us are happy when we get word that our home price has gone up. And thanks to refinancing, we can access some of that money (for a price) by borrowing against the new value. But nothing will change the fact that investments don't make you any money until you sell them, and this applies to your home, as well. If you are counting on the value of your home to help you in retirement, keep in mind that without some creative help from family members, this will mean a reverse mortgage or a sale. And if you choose the latter, you are going to have to find somewhere else (somewhere less expensive) to live.

All of this is not to say that your home in not a good investment. It may very well be! The mortgage tax deduction can offset some of those interest payments, and if you buy in the right time and place you could make a lot of money when it is time to sell. What all of this does mean is that averages will do you no good in determining whether you should by a home. You need to do the calculations based on things like how long you plan to stay in the area, what other resources you have in case of a downturn, what the rental market looks like in your area and what other financial and familial obligations you have.

Most importantly, though, you need to account for the fact that what you are buying is not a house...it's a home. If flexibility, adventure, ease or mobility are what you need at this point in your life, there are probably better investment options for you. If, on the other hand, buying a house ensures that you can keep the kids in school with their friends or that you can finally set down roots in a community, well, that is another kind of investment—one that doesn't come with a calculator but makes a world of difference.

Getting A Mortgage 101

We've had a number of clients in the office lately asking about qualifying for mortgages. Despite the fact that just about everyone and everything in U.S. policy is trying to get us to buy homes, we Americans are often confused about how our mortgage system works. So here are the basics to know before you go shopping for a mortgage:

Down Payment Realities

Before the 2008 housing market crash, banks had all sorts of inventive programs to get people in new homes. It turns out some of them were too inventive, and banks are back to some more familiar requirements. If you can do it, your best bet is to put at least 20% of the total price you are paying down on the house. Why? A 20% down payment will almost always get you a better interest rate. And since your large down payment is considered less risky for the bank, you won't be required to pay private mortgage insurance (PMI). Folding the PMI into a higher interest rate might help, but there is no way around the much higher cost, in loan terms and PMI if you dip below that 20% down payment.

But....

If you are going to have trouble coming up with a larger down payment, you might qualify for a special loan through the USDA's zero-down payment for rural low-income buyers, VA loans for veterans, Fannie Mae's Homepath Program or a first-time home buyer program in your area. Start with the link to HUD's website at the bottom of this post if you think you might qualify for home buying assistance.

Know Your Ratios

For obvious reasons, most people figure that they can afford a mortgage if the monthly payments are comparable to their current rent payments. But banks takes a completely different approach to whether you can afford a mortgage—they use very specific income-to-debt ratios. Here's how the math works:

The first number the bank will calculate (the "front" ratio) is the percentage of your income that will need to go to housing costs. In this case, your income is everything you earn before taxes*, and the housings costs include mortgage payments, taxes, insurance and even homeowners or condo association fees. Let's say you gross monthly income is $5,400, and your monthly housing costs are $1,800. That give you a front end ratio of 33% (1800÷5400=.333).

Now for the "back" ratio—use the same numbers as above but add your consumer debt (car loans, student loans, credit card debt payment, etc...) to your housing cost. If the consumer debts were another $500 per month, you would add that to the $1,800 for a total of $2,300. Now divide that $2,300 by the same $5,400 income as before and you get about 43% (2300÷5400).

Your ratios will be written: 33/43 ...and you will probably have trouble with your bank. Why? Because while a 33% front ratio is just fine, banks are usually looking for a lower back ratio—something closer to 38. Some of the subsidized loan programs I mentioned above might let you go up to 41 on that back ratio.

Know Your Terms

In addition to interest rates, down payments and mortgage insurance, the way that you repay your mortgage loan can vary. A 10-year mortgage means lower monthly payments but less interest paid over time; a 30-year mortgage can lower your monthly costs, but means you will pay substantially more interest over the course of the loan.

You also need to watch out for the difference between fixed rate mortgages (your interest rate & payments stay the same until the mortgage is paid off) and Adjustable-Rate Mortgages (ARM's). Most banks will offer you a lower initial interest rate if you are willing to sign on to an ARM, but there's a big down side. ARM's mean that you (and not the bank) are taking the risk that rates might go up. In that case, you could end up paying much more per month or having all of your payments go to interest (which means that your loan could actually be getting larger!). Because of this unpredictability, we usually recommend fixed-rate loans if you are buying a home.

Be Prepared

Now that you know how the calculations work, you should have an idea of what you can do before you go to the bank to put yourself in a position to get the best terms on your mortgage:

1. Save up for a healthy down payment of 20% if at all possible (that will not only get you a better interest rate but also reduce your monthly payments, which means better ratios);
2. Lose the consumer debt payments. As you can see, paying off some of those consumer debts can make all of the difference in qualifying for a mortgage. Even if you qualify, waiting until you have debts under control can improve the interest rate you get;
3. Rehabilitate your credit score. This one gets lots of press, and for good reason. The interest rate you will get and often, you ability to qualify for a loan at all depend on your credit rating. Fortunately, you can improve your rating if it has fallen over the years.

Find A Good Bank

Mortgages work just like any other product—you need to shop around. If you belong to a credit union, start there, but be sure to talk to a few different lenders before you make a final choice. You might also consider a mortgage broker, who will scout around for you to find the best offer (be aware, though, her fee is paid by the bank that secures the deal so she is not working entirely for you).

Don't be tempted to skip this step! Banks can offer wildly different terms and rates for the same home purchase, which means you could end up paying thousands more for your home loan.

Check Out Resources

The U.S. Department of Housing and Urban Development (HUD) provides step by step information for home buyers, including links to home buyer programs in your area. Check them out on HUD's site.

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*Note that you have to be able to document your income, usually through tax returns. Self-employed buyers can still qualify, but the process may be slightly more complicated.