Home Buying Series Part V: Should you get a HELOC?

Now that you have found a house you can afford and decided on a mortgage, your mortgage broker may ask you if you would like a Home Equity Line of Credit (HELOC). If you are just buying this house for the first time (with 20% down as suggested earlier in this series), I would advise saying, "No thanks."

However, if you have been in your home for several years, have significant equity in the home, and find yourself in a couple of situations I would consider a HELOC. First, if you plan on investing in something that will pay for itself (new insulation for instance) over a long period of time a HELOC could make some sense as it would allow you to start reaping the benefits now. Note: there are very few investments you will make in your house that have this kind of return. Second, if you find yourself with significant credit card debt and the HELOC is offering a much lower interest rate it may make sense to use the HELOC to pay off those cards at a lower rate. Finally, if you need a new roof and you don't have any cash to fix it a HELOC might be your only good option.

HELOCs are basically just ARMs but they generally float right away. They are a fixed line of credit that you can draw on a little at a time, pay back, and then draw again up to your maximum like a credit card. You can choose to only pay interest on them for a certain period of time (typically 5 to 10 years) and then they begin charging principal too. The interest on HELOCs is generally tax deductible up to $100k. In my opinion HELOCs are generally to be avoided, though you can see a couple cases above where I might consider making an exception.

Home equity loans are another, possibly better option, but they are usually just a lump sum. You can't draw on them, then pay them off, then draw again. The good thing about home equity loans is that you can get them in a fixed interest rate (basically this type is just a second fixed mortgage). If you are using some of your home equity to invest in your home for a one time project (like the insulation mentioned above) a home equity loan with a fixed payment might be the way to go so you avoid monthly payments that bounce around.

The big risk with both of these options is that they provide you with the opportunity to overextend yourself and risk losing your home. If for some reason you can't pay your HELOC or home equity loan, you have a good chance of ending up in foreclosure since both products involve a lien on your house. I'd advise avoiding both products altogether unless you have a compelling need to use them.

Home Buying Series Part IV: Avoiding Junk Fees on Your Mortgage

When you go to get a loan your mortgage broker should give you a good faith estimate before you agree to go with them for the loan. This estimate tells you your rate and lists a number of other fees. What many people don't know is that many of these fees are highly negotiable. The fees usually don't represent anything specific but actually cover your mortgage broker's overhead. Especially if you are already agreeing to paying any "points" you should definitely not pay much more in the way of junk fees.

Here is a list of common expenses on the good faith estimate that are widely viewed as "junk fees":

• Processing Fee
• Underwriting Fee
• Document Prep Fee
• Settlement Fee
• Bank Inspection Fee
• Lenders Inspection Fee
• Application Fee

"Real" fees typically include title fees, government recording fees, an appraisal fee (you should get a copy of the 3rd party appraisal).

Now it should be made known that you probably cannot get all junk fees to go away, but when you are comparing lenders don't look at the amount of the different fees, just sum them up and view the total junk fees as a point of comparison. See if you can negotiate these total junk fees down, it doesn't matter which specific ones go away. You will likely get some song and dance about how they do have to process your application, etc. but don't budge. Junk fees are a direct cost to you and the lower they go the better off you are. Play two lenders off each other on the junk fees and get them way down especially if they are offering essentially the same interest rate.

Home Buying Series Part III: How Much House Can You Afford?

How much house can I afford? It seems too many home buyers forgot to ask that question before they got caught up in the buying bonanza of the last few years. That's why foreclosure rates are spiking. A lot of people fell in love with a house and then asked their lender how they could afford it. During a period of incredibly loose credit lenders were happy to oblige and put people in houses they couldn't afford using low or no doc loans, interest only loans, neg am loans, and little or nothing down.

How Not to Become a Statistic

There are generally three criteria for getting a conventional loan without mortgage insurance:
1) You have to make a 20% down payment on your house
2) Your monthly mortgage payment (including interest, principal, taxes, and insurance) can't be more than 28% of your gross income.
3) Your total expense obligations (i.e. your mortgage + all other debt payments) can't be more than 36% of your gross income.

It turns out if you stick to these rules you are much less likely to end up in foreclosure than someone who strays from them. For instance, if you look at the most recent Mortgage Banker's Association survey you can see that subprime and FHA borrowers (who typically have bad credit and make minimal down payments) have much higher delinquency rates (around 13%) than those with conventional mortgages (less than 3%). Now this is probably not an entirely fair example because subprime borrowers usually have bad credit to begin with so they are probably more likely as individuals to default on their mortgage anyway, but general idea is correct. Prime borrowers could afford their mortgages and subprime borrowers generally could not which is why 13% of them are delinquent.

Many people will tell you that you don't need a 20% down payment on your house. I disagree for three reasons. First, if you can save the 20% down payment, you probably have the financial discipline to make your mortgage payment. Second, that 20% provides you a cushion from an unusually soft housing market (which is what we are currently in). If you only put 5% down and then the value of your house declines by 10% you will actually owe the mortgage company money if you decided to sell right then. Real estate prices rarely fall by 20% so you should almost never run into this problem if you put 20% down. Finally, if you put down less than 20% you need to pay for mortgage insurance (typically adds 0.5% to your interest rate) which is a totally ridiculous thing to do in my opinion if you have every intention of paying your mortgage.

To get an idea of how much house you can afford, I recommend trying this mortgage calculator from CNN Money. It will tell you how much house you can afford based on your income, debt, and the interest rate you think you can get on a loan. It conforms to the 28% mortgage payment rule and the 36% total debt service rules. It also assumes you will put down 20% and avoid paying mortgage insurance as a result. For a quick view of what interest rate you might expect to pay visit Bankrate and look at the rate on the 30 year fixed mortgage.

Finally, to learn a lot more about mortgages visit The Mortgage Professor. His site is so in depth you might find yourself drowning a bit, but you will find the answer to almost any question there.

As always the Armchair Fiduciary is happy to field your quesitons. Email me at armchairfiduciary_at_gmail.com.

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.

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. Broadcast.com) 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 dot.com 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!