Sunday, June 24, 2007

Home Buying Series Part II: An Introduction to Mortgages

Now that you used Zillow to help you find a good home at a good price it's time to think about how you will finance that home. That's where a mortgage comes in. At its most basic level, a mortgage is a loan from a financial instituion to you which has your house as collateral. In laymen's terms, the bank has a claim on your house and if you don't pay them their interest, they'll take the house as payment instead (i.e. foreclose).

Fixed Mortgages

Fixed mortgages are mortgages that are at a fixed rate interest rate over the life of the loan. For a 30-year fixed mortgage both interest and principal will be amortized (i.e. spread out) over 30 years so at the end of year 30 you will owe $0 to the bank and own your home outright. A 15-year fixed mortgage will result in a zero balance at the end of year 15. Typically the shorter the duration of the mortgage the lower the interest rate you'll have to pay, but the higher your monthly payment will be (because your principal is amortized over a shorter period of time). Fixed mortgages give you the security of stable payments over the life of your loan, but usually carry slightly higher rates to begin with than ARMs. If you plan on staying in your house for over 7 years, I'd advise sticking with a fixed rate mortgage.

Adjustable Rate Mortgages (ARMs)

ARMs are loans that start out at a fixed rate for a certain period of time and then begin to adjust every so often (usually once per year). Usually there is a particular interest rate to which the ARM is tied which in ARM lingo is called an index. As the index goes up, so the rate on your ARM goes up. Common ARM indexes include: COFI, MTA, CODI, Prime Rate, and LIBOR.

Most ARMs come with a period cap and a lifetime cap. The period cap is the maximum amount your rate can adjust up in any given period. For many annually adjusting ARMs this is around 2%. This means if you start out paying 5% then the most your ARM can adjust to is 7% after its first adjustment period and 9% after the second, etc. A lifetime cap represents the maximum amount your interest rate can go up over the course of the loan. For many ARMs this is 6%. So if you start out at 5% with a 6% lifetime cap, the most you can ever pay is 11% (which is a lot especially compared to the 5% teaser rate).

You may have seen 3/1 ARMs and 5/1 ARMs. These are loans that start out fixed at the low teaser rate for the same number of years as the first digit (i.e. 3 years or 5 years). The second digit represents how often the ARM adjusts after the fixed period, these loans adjust once per year as is typical.

So by now you have probably figured out that ARMs can be pretty complicated. If you plan on living in a house for only 5 years, then a 5/1 ARM can probably save you money because you will pay a low rate for the first 5 years and then sell the house (and pay off your loan in full) so you won't be paying when the chance for higher rates hits. Other than that, taking out an ARM is a gamble on interest rates which very few people can predict accurately. Generally, I would advise against ARMs unless you plan on paying off your loan in full before the ARM adjusts.

As a side note, if you need to use an ARM to afford a house, you are buying a house that is beyond your means! Do NOT do it as you are likely to end up in financial trouble by the time your ARM floats. You can always move to a bigger house later, but recovering from bankruptcy is much harder to do (i.e. takes 7 years at least). If you need an ARM to afford your house, do the right thing and find a smaller house that you can afford with a fixed rate mortgage. My next post will walk you through how much house you can afford.

Loans to Avoid: IO and Neg Am

There are also a couple of loans worth outright avoiding for the average individual. These include IO (Interest Only) loans and Neg Am (Negative Amortization) loans. These are loans that are for the most part designed to get people who can't afford a certain house into that house. They are very risky and will usually end in financial ruin for the homeowner. Indeed many financial instutions that were pushing these types of loans recently went bust when the homeowners who had these loans defaulted on them. Unless you REALLY know what you are doing these types of loans are to be avoided at all costs.

Wednesday, June 20, 2007

Home Buying Series Part I: How to get prices for any house even Mark Cuban's!

Knowledge is power in all things financial. The guy with more and better information usually wins when it comes to money. That is why when it comes to buying a house having a reliable source of independent pricing data is very important. That's where Zillow comes in. Zillow aggregates a bunch of sales data and uses algorithms to arrive at estimates of homes' values which they call Zestimates. Now the algorithms aren't 100% perfect and there may need to be some corrections, but the Zestimates should be in the ballpark for any average house. To get comps you used to have to call a realtor, Zillow lets you look at this data from the comfort of your own home.

For instance let's say Mark Cuban got sick of living and Dallas and was going to sell his home. You pull past 5424 Deloache Ave. and see a big sign out front that says, "For Sale by Owner." Knowing that you must have this house, you rush home and punch the address into Zillow. Here is what you get:

Now you know Mark's house is worth approximately $13.5 million. Thanks to Zillow you can avoid the mistake of insulting Mark by offering him only $10 million for his humble abode and having him slam the door in your face. Instead, you can step in with your $13.5 million "fair value" offer and see what Mark has to say. However, if history is any guide, Mark's not a seller unless he gets a big return (e.g. so you had better offer $20 million just to be safe.

As a side note, I have nothing against Mark Cuban and I hope he doesn't mind this post (I am sure there's a small chance he'll be on IceRocket reading it). I don't know him personally and I found his address via the Dallas Central Appraisal District. I enjoy his blog. While I don't agree with everything he does or says, I do think his views on the Internet and the future of video are pretty thought provoking. I don't care about the Mavs or the NBA so I don't really have a view on his antics in that arena. In the fiduciary category Mark has obviously been a great steward of his own capital. A lot of guys drank the kool-aid during the tech bubble. He, on the other hand, made his money and then got diversified. He held on to a lot more of his fortune than most people as a result. He gets an Armchair Fiduciary gold star for that.

Armchair Fiduciary's Home Buying Series

Per my wife's suggestion I am going to do a number of posts over the next few weeks related to buying a house especially aimed at first-time buyers.

Topics I will cover include:

  • Finding good price data
  • An introduction to the various types of mortgages
  • How to clean junk fees out of your "good faith" mortgage estimate
  • Determining how much house you can afford
  • What are HELOCs and should you get one
Visit the Armchair Fiduciary frequently over the next few weeks for all this and more!

Sunday, June 10, 2007

Mistakes to Avoid When Renting a Car

I was out of town this weekend and consequently had to rent a car. There are basically only 3 rules you need to know in when you rent a car.

1) Never take the rental company's insurance policy unless you don't have a car of your own with auto insurance. The rental company's insurance is generally a $25-$40 per day rip off because your insurance already covers rental cars. If you don't have your own car and insurance you should definitely buy theirs (better overpriced insurance than none at all).

2) Never take the "fuel option" which involves paying modestly expensive prices for a full tank of gas and then being allowed to bring the car in empty. There is very little chance you drive the car back into the rental place on fumes and, unless you do, you are giving the rental company free gas. You are generally much better off topping the car of on your way back to the rental place and returning it "full." Unless you are always pressed for time you will come out ahead filling up yourself.

3) Be sure to report any problems with the car before you leave or you may be held responsible for the damage. This is especially true if you are a "frequent renter" (e.g. Hertz #1 Club) and don't need to check in at the desk. I one time drove a terribly smokey smelling car for a whole weekend because I didn't bother to complain about it before I left; it just wasn't worth it.

Happy driving!

Monday, June 4, 2007

Is your car worth less than $5,000? Consider canning your comprehensive insurance.

Chances are if you are as frugal as the Armchair Fiduciary at some point you will end up driving a car worth less than $5,000. If you find yourself in this position, it might be time to cancel your comprehensive insurance and save yourself a few hundred dollars annually. In case you don't know comprehensive insurance is one of two types of car insurance. Comprehensive car insurance covers non-accident related damages such as hail, vandalism, and theft. Collision insurance is the other kind of insurance and it covers damage to property and people (i.e. medical bills) as a result of an accident. It is generally required by law in the United States.

Before delving too deeply into why one would cancel comprehensive insurance, let's understand the basic concept of insurance. Insurance companies sell policies to individuals to protect them from adverse events. The insurance company, a little like a casino, doesn't mind losing once in a while because they use statistics and the law of large numbers to predict what their losses will be and then they price their policies such that the house will win over the long term.
Individuals buy insurance because they are risk averse (and in the case of auto insurance because they are often required to by law). Risk aversion means that you don't like big negative surprises. For instance, if there is a 1/100th chance that you will lose $99 and there is a 99% chance that you will make $1 the expected value of the situation to you is $0. A risk neutral individual should not care about the outcome because their expected value is $0. A risk averse person might be willing to pay slightly more than $1.00 for insurance to protect against the $99 potential loss. This guarantees a return of slightly less than $0, but also avoids the off chance of a big loss. This may seem irrational at first but lets consider a slightly different situation where the loss is $99,000,000 and there is a a 1/100,000,000th chance of that outcome but the gain is still $1.00 the rest of the time. In this scenario giving up a few pennies might seem like a more rational decision than risking a huge fortune even if the chances of losing it are remote. When the pain of losing a lot of money is a lot more than the benefit of a higher expected value, that is risk aversion.

While insurance companies can spread their risks over thousands of customers, an individual customer only gets one shot and they therefore have a reason to be risk averse, nobody wants to be the one out of 100,000,000 and lose everything just because they are unlucky. Buying insurance helps you avoid “becoming a statistic,” but the insurance company will charge you something for the privilege.

So by now you may understand why getting rid of comprehensive on a cheaper old car may make sense. You can increase your expected return because the insurance company is going to charge you a little more for comprehensive insurance than is statistically fair so that they can make a profit. If losing your car would not bother you that much and you can afford taking a $5,000 risk then you should cancel your comprehensive insurance and just carry the collision/liability insurance required by law. This should yield you several hundred dollars of savings per year and improve your expected value while exposing you to the remote risk of a $5,000 loss if your car was totaled due to vandalism, hail, etc.