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.

Some Hope For Student Loan Holders

If you have student loans, figuring out the best option for paying them off is one of the most important things you can do for your financial future. But we should all be keeping an eye on the changes to how Americans will pay for higher education. Here are some of the new or potential changes in student loan laws and regulations...

Income Based Repayment Improvements

Income Based Repayment plans are only for federal student loans that are not currently in default (those who are in default can access them once they've gone through a loan rehabilitation period). At first, they limited your payments to 25 years and no more than 15% of your income; some now limit payment to 20 years and 10% income. What we have currently is a confusing tangle of IBR-type programs with slightly different names and terms depending on when you took out your loans. But with student loans a hot topic in Congress and the press, there is talk of making the better terms available to more existing student loan holders. To see where you stand right now, check out IBR Info's very helpful site.

Refinancing Options

There are plenty of private banks ready to help you refinance your student loans by moving your debt over to them. Given the ridiculously high fixed interest rates on many of our federal student loans, this could be a great move. Unfortunately, you have to qualify for the new rate with a private lender and, in many cases, end up paying origination fees or variable interest rates that will go up later. More disturbingly, you lose the protections offered by federal loans.

Recently, some of our Members of Congress have suggested that the Fed's should also be refinancing—going back to lower the rates for students paying far more than if they had borrowed under recent loan programs. So far, this hasn't worked, but with some loan holders paying 8.5% for 20 to 30 years while others pay only 6%, our current system raises questions about just how fairly the government is treating its students. How much are you paying?

Bankruptcy for Private Loans

There have been rumors around for a long time that it is impossible to discharge student loans in bankruptcy. In fact, Congress did make it extremely difficult. And given the options for repayment available through federal consolidation loans, it would be hard to convince a bankruptcy court that your federal student loans are an undue hardship that can't be addressed except through bankruptcy. But this argument doesn't hold for private student loans, and since 2005, private loans have also had the benefit of extra bankruptcy protection. The Fairness For Struggling Students Act of 2015 (S.729) would get rid of extra challenges to discharging private student loans in bankruptcy. The Student Loan Borrower Assistance site offers a good run down on what the laws are.

Better Programs for Extreme Need

Once upon a time we had Pell grants (not loans!), Stafford Subsidized Loans and Perkins Loans that covered all or most of tuition costs for students who had extreme financial need. Since then, tuitions (and other costs) have soared while federal programs to help wilted. Even if Congress can't keep up with the irrational hikes in higher ed costs, a better tracking of inflation would make a big difference in getting upwardly mobile students, well, upward. Want to see the difference between a subsidized and an unsubsidized loan? Click on the image to see a comparison:

Change The Whole System?

This one is a long shot—but not as much of a long shot as it was even a few years ago. We seem to have reached unanimous agreement that we are doing now just doesn't work. Is the solution to make all student tuition costs into a form of IBR program? To follow the lead of Germany and other countries in which nationally funded higher ed programs are free? To tax the industries that benefit most from our higher education systems and use that to pay for undergraduate degrees?

What is your idea for making higher education accessible to all Americans without leaving our country in debt?

Wrestling Your Student Loans Into Submission

Wrestling Your Student Loans Into Submission

It seems that voters and politicians are at last paying some attention to the issue of student loan debt. It's about time. But while the folks in D.C. hash it all out, here are a few pointers for dealing with your own loans:

1. Remember, Student Loan Debt Is Not A Moral Failing.

One of the consequences of not having a public debate on loans for so long is that we've had a tendency to think of student loan debts as somehow embarrassing—as if you went on a credit card-backed drinking binge instead of years of late-night papers and science lecture halls. For a country that swears up and down that education is the key to economic progress, this is ridiculous. You have loans because you needed them. Now let's talk about getting rid of them...

2. Should You Consolidate?

Under the constantly changing regulations from the U.S. Department of Education, people who have federally-backed student loans (which are most student loans these days) can choose to consolidate all of their little loans into one Direct Consolidation Loan.* This makes the bill paying easier, but it isn't necessarily your best bet. The question you should start with is, can I afford to make my payments under my current plans? If not, a Consolidation Loan almost always offers longer payment periods (up to 30 years) and more flexible payment plans. Sounds good, but these generally mean you pay more over time, and can eliminate some of the forgiveness options or other benefits you might have had with individual loans. Check the Federal Student Aid Office's consolidation page for more information;

3. Pay Attention To Rates!

When you first took out your loans, you probably had no real choices when it came to the interest rates. U.S. Government Loans almost always have lower rates, but those are adjusted each year, and there is plenty of variety within the same program. By way of an example, click on this chart of federal student interest rates to see where things stand for new student loans in 2015-2016 academic year:

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Unless you were lucky enough to get a subsidized loan, those interest rates began compounding while you were in school. Once you've graduated, you might have some options for bringing them down. Check the rates on your current loans and note whether they are fixed rates or variable rates. Federal Consolidation Loans will average your interest rates from these loans, giving greater weight to the larger loans. Use the Department of Education's calculator to figure out what the Consolidated rate would be and ask yourself, am I better off now? In the long term?

4. Use Your Options

Most federal student loan programs, including federal consolidated loans, carry with them some great benefits that too many loan holders still don't know about. Do you work full-time for a government organization or nonprofit? Under the Public Service Loan Forgiveness Program, you could have the remainder of your debt forgiven after ten years of regular monthly payments. And that works even if you choose an Income Based Repayment (IBR) Plan (or the closely related Pay As You Earn Plan, Income-Sensitive Plan and Income-Contingent Plans) that sets your payments at a percentage of your income.

Even if you can't put in ten years at a public service job, one of the repayment plans can cap how long (how many payments) you have to pay before your loan is then forgiven. Right now these limits are at 20 or 25 years. Which plan you qualify for depends on your loans and when you borrowed them, but the Federal Student Aid Office offers you this nifty chart for a quick view of what's out there;

5. Use Your New Private Options

If your loans are older, especially if you were forced to take out private loans in the years before 2007, you may find that some of these programs don't apply to you. Recent regulatory changes have been opening up options for you outside the federal programs. A new host of private lenders are offering refinancing at better interest rates than some of the old federal loan monsters. Evaluate them carefully for 1. loan origination fees; 2. variable rate terms that could send your interest rates skyrocketing; and 3. availability of deferral, forbearance or other options. This will take a little applied mathematics, but you could save yourself significant money with refinancing;

6. Time Heals All Wounds

For most students, the impulse is to get the loans repaid as quickly as possible. It's a good impulse and a financially sound plan. But it may not be realistic depending on your income and your loan size. If you are looking at a mountain of student loan debt and feeling defeated, make sure you have the right loan repayment plan in place and remember that your own circumstances will just keep changing, and so will the loan repayment programs. Find that balance between sacrificing for the future and making something great out of the present—after all, that's what your education has qualified you to do.

*Parent PLUS loans can not be consolidated and do not offer special repayment terms. Perkins loans can be included in repayment plans after they have been consolidated with another direct loan.